DATE 2/14/06

CORR. FILE Larry King

ACTION: Alan Stape Dennis
Jessee Theresa John B.

SUBJ. FILE

CROSS REF.

Maggie Suzanne Rose

STAFF MEMO

COMMENTS:

DC OFFICE:
Christie/Jody/Ann

INFO COPY TO:

ROUTE CC COPY TO:

TO BE FILED N

# La Grande Muraille nucléaire du IIIe millénaire
## Les Remparts de la Liberté

> « Poser aujourd'hui la question de la défense antimissile de l'Europe est essentiel si nous voulons que l'Union Européenne, même si elle continuera de disposer à l'avenir des forces nucléaires françaises et britanniques, puisse préserver son autonomie de décision dans un monde incertain et dangereux ».

Amiral Jacques Lanxade, ancien Chef d'état-major des Armées

À l'aube d'un IIIe millénaire imprévisible et de la prolifération des armes de destruction massive, les États-Unis construisent, avec un bouclier antimissile et un glaive nucléaire, la plus fantastique des grandes murailles. Pour s'élever dans la compréhension des décisions américaines, une descente passionnante dans les entrailles de ce monde secret vous est offerte par l'un des guides qui le connaît le mieux. Bien des surprises attendent le visiteur.

Dans ce bouleversement stratégique, la France pourrait perdre le peu d'indépendance militaire qui lui reste et sa marge de manœuvre politique que lui donne son arsenal nucléaire. La France seule ne peut s'offrir un bouclier. Doit-elle convaincre d'urgence l'Union Européenne de se doter d'une grande muraille ? Lassée de subir l'hégémonie américaine, l'Europe saura-t-elle hisser les voiles de l'indépendance ou n'être qu'un protectorat américain ? Aura-t-elle la volonté politique de se doter de ses propres instruments stratégiques pour protéger ses intérêts vitaux ? À ces questions plus actuelles et brûlantes que jamais, Bernard Lavarini apporte, par des réponses claires et non convenues, l'éclairage d'un scientifique sur les enjeux stratégiques d'avenir.

Expert auprès du Premier ministre pour les questions de défense de 1997 à 2002, **Bernard LAVARINI** est le père de la première arme laser française. Il a également assumé la direction de la prospective au sein de Thomson-csf, l'un des plus grands groupes mondiaux de l'armement. Il est l'auteur de nombreux comptes-rendus, articles et de l'ouvrage **Vaincre sans tuer sur les armes non létales (Stock-1997)**.

9 782747 592987

ISBN : 2-7475-9298-7

27 €

Larry King
Bill Adler Books, Inc.

10 East 39th Street
New York, New York 10016

212-972-1445

London: 44 (0) 20 8133 2972

Fax: 212-972-1448

larryking@billadlerbooks.com

June 14, 2006

JUN 16 2006

Mr. Henry Kissinger
350 Park Ave.
New York, NY 10022

Dear Mr. Kissinger,

"I knew what my job was, it was to go out and meet the people and love them." This quote by Princess Diana of Wales embodies her inspiring compassion for the unfortunate and her unrestrained love for those in need. Her legacy of kindness and charity continues to encourage the world to follow in her footsteps, and her memory lives strong in the minds of the countless people she touched throughout her life.

In honor of Princess Diana and her work, I am asking important and successful people to share with me their remembrances of her as a friend and inspiration to all. As an advocate, ambassador, fashion icon, friend or charity worker, Diana affected all of us in many ways with her unique character and impressive style and compassion.

I would like to invite you to join me in my next book to be published internationally by Crown Publishers on the 10th anniversary of her death, tentatively titled:

Memories of Diana

Your submission may be any length and in any form, from a few sentences to several pages. I will need your submission by July 25, 2006. You may mail, email, fax, or dictate it to us at the address and numbers on this letter.

We believe that the book will be an international bestseller and a fitting tribute to her memory, and I will be discussing the book on my program on CNN. A percentage of the author's royalties will be donated to charities that work to sustain the humanitarian causes that Princess Diana began during her extraordinary lifetime.

The publisher requests that you sign the attached release form so that we may include your contribution in the book. Please mail or fax this form at your earliest convenience.

Best personal wishes,

Date: June 14, 2006

To: Mr. Henry Kissinger

From: Larry King

I am requesting permission to reprint the following material:

[Please provide a brief description of the material to be used, be it poetry, prose, lyrics, letters, photographs or artwork, published or unpublished. Alternatively, you may use a copy of the material as an attachment to the letter and then simply refer to the attachment]

for use in a book titled *Memories of Diana*, edited by Larry King (hardcover, Crown Publishers, August 2007).

Will you kindly give the editor and publisher permission to reprint the material indicated above in all editions, derivations and formats of the work, including any electronic, audio, and foreign language editions, as well as any serializations, condensations, excerpts, digests, etc., in newspapers, magazines, etc.? Full credit will be given to you as the author of the material.

For your convenience, a release form is provided below. In signing you warrant that you are the sole owner of the rights granted herein and that the work does not infringe upon the copyright, or other rights, of anyone. An additional copy of this letter is enclosed for your files.

IRREVOCABLE PERMISSION IS HEREBY GRANTED FOR USE OF THE MATERIAL AS STIPULATED.

AUTHORIZED SIGNATURE: ____________________ Date: ___________

Nemir Kirdar regrets he is no longer
available for the lunch you had
scheduled on Tuesday, March 14.

Would you like me to see if Beverly Sills
is available? (She called last night to
set a lunch date and I had given her one
later in March, but she mentioned being
available Monday & Tuesday of next week.)

Yes; see if Sills is available <input checked="checked" /></

Prefer __________

JL

Dec 04 06 10:04a

Teresa Hartnett

703-719-7666

p.1

The
Hartnett
Agency

At Work
in the
Marketplace
of Ideas

6609 Tenth Street #A2
Alexandria
Virginia 22307
703-660-6799 P
703-660-1309 F

www.
thehartnettagency
.com

December 4, 2006

Dr. Henry A. Kissinger
Kissinger Associates
350 Park Avenue, Floor 26
New York, NY 10022

DEC 04 2006

**Time Sensitive**

Dear Dr. Kissinger:

My note carries to you the sad news of Jeane Kirkpatrick's seriously declining health, which has befallen her only months before her first book in ten years, MAKING WAR TO KEEP PEACE, will be published as the #1 title on HarperCollins' spring 2007 list.

Only because she is not able herself to ask you, I make bold to inquire if you would be willing to consider writing the preface. It is something she and I only spoke about before her health curtailed her activities.

The preface would be needed at your soonest convenience, although, having said that, I believe HarperCollins would be willing to adjust publication to incorporate your words.

I have the great honor of being Jeane's agent, whom she found due to my specialty in conservative authors and came to trust as we wrestled this amazing work of wisdom onto the page. This book was hard for her to write in that, with qualification and grace, she felt current policy needed correction.

In the past year, Jeane also invited me to call her "friend," and it is with the heavy heart of a friend that I ask of you this favor on her behalf,

Warm wishes,

Teresa Hartnett

JUN-29-2006 16:23

FROM HAK DC OFFICE

TO THERESA OFC

# My Motivation – My Goal – My Plan

I chose this project because I am very interested in medicine and in the differences between being a veterinarian and a human doctor. As I might want to study veterinary medicine when I finish school, I think it is important to start researching the subject now to learn about the prerequisites and adjust my choices in school accordingly.

The goal of this project is to investigate the differences between being a veterinarian and a human doctor. This investigation will cover the education, lifestyle, duties and other important information about the two careers.

My project should be based on a wide range of information. Therefore, I decided to complete it the following way:

1. I will observe and help at an animal hospital to learn more about being a vet.

2. I will design a questionnaire and send it to veterinarians and human doctors asking questions about their job and their specific education.

3. I will go on the Internet to find out about which courses one should take at school to prepare for studying veterinary or human medicine. As my project is more focused on the veterinary schools, my research on this topic will be more intense.

4. Based on the data collection I will summarize the findings in a poster.

JUN-29-2006 16:23

FROM HAK DC OFFICE

TO THERESA OFC

# Reality Strikes

## Step 1: Finding an Animal Hospital

Step 1 was to find an animal hospital that would permit me to observe their daily routines. I asked a number of pet owners who they would recommend as a vet. Also did I ask them, how they would describe the type of clinic. I was looking for good practice and a broad range of activities, ideally from normal pet routines to real surgery. Given that I had been an intern at a veterinary hospital in Connecticut during my stay in the USA, I also found an animal hospital close to Munich/ Germany where I was allowed to help.

I went to the animal hospital for two days during spring break and one week in the summer. While there, I took notes about what I learnt and how I felt about watching the sick animals. During the summer, I joined the appointments the vets had and assisted them with holding the animals while they were treated. I also cleaned the cages of those animals that had to stay overnight. Furthermore, I helped with and attended the preparation for surgery, the supervision of sedated animals and the supervision of the animals waking up after surgery. A very interesting part was watching those surgeries and assisting with preparing the tools. My highlight was being allowed to stitch a wound in the gum.

I realized that being a vet is physically demanding as lifting big dogs or standing in surgery for more than an hour can be very exhausting. Also, dealing with the pet owners and their emotions requires a lot of patience.

## Step 2: Creating a Questionnaire

Step 2 was to create a questionnaire for gathering personal information about practicing veterinary or human medicine. I realized that the questions needed to be similar in both questionnaires in order to compare the two careers later. I thought about those topics that would be helpful and critical to decide whether to become a vet or a doctor.

While collecting possible questions for the questionnaire, I realized that I have to be careful not to ask too personal questions in the questionnaire so that the people answering it do not feel uncomfortable. Therefore, I decided to leave out the question about how much money they make and how much college costs. I decided that I can find answers about tuition cost on the internet. Another important decision was to treat the answers anonymous and not to quote people because that might keep them from answering truthfully. It was also important to communicate this to all respondents early on when they received the questionnaire.

Once I had the questions assembled and complete, I had to think about whom I can send them to. It was then that I realized I need to translate the English questionnaires

4

JUN-29-2006 16:23

FROM HAK DC OFFICE

TO THERESA OFC

# Key Findings

## *The Process - How it all turned out*

Nothing replaces the direct experience in an animal hospital. This was great. I had already enjoyed my time at the animal hospital in the USA as well as here in Germany.

The questionnaire was what helped me gather enough valuable information after the disappointment of the internet. It allowed me to not only base my findings on my own experience in two animal hospitals but also to tap into the broad experience of doctors that have been practicing for many years. It helped me to get further insights on both professional and personal aspects of the careers. I also got "real life" answers from the questionnaires which added facts as well as emotions as it came from doctors answering honestly and openly and being passionate about their work at the same time.

Overall, the whole process was very successful and only one vet did not return my questionnaire. I guess that was because the vet did not know me personally and only got the information via a friend of my mother. Some information might not have been transferred correctly and therefore, the vet decided not to fill out the questionnaire.

## *Being a doc - More than just a job*

While being at the veterinary hospital, I learned many things that I will carry with me for my life. I realized that being a vet is a 24 hour job and that it is very exhausting. Treating animals is sometimes harder than treating humans because we don't know and often can not tell what the symptoms of the animals are or where they come from. After all, humans can speak - animals can't. In treating an animal, the vet often has to rely on the owners of the pets to give them some indications on the symptoms. Furthermore, sometimes convincing the pet owners to do something the sick animal can profit from can be very tiring and requires a lot of patience. In addition, as the animals can sense how people feel, a vet always needs to be calm and patient, even if the animal is wild or aggressive.

The saddest thing I experience was dealing with animals that could not be cured anymore and therefore need to be euthanized. Seeing how the owners react after hearing this bad news made me feel very sad and I had a hard time coping with it. The only thing that helped me was that I told myself that the animal was very sick and that it would be better for it not to suffer any longer.

Unfortunately these sad moments are also a part of the life of any doctor. Life will not only be filled with the very positive and rewarding achievements like healing or

6

JUN-29-2006 16:24

FROM HAK DC OFFICE

TO THERESA OFC

saving a life. On some days it is filled with massive grief, about a bad diagnosis or death. This must be the biggest challenge for every doctor. Distance one self from such disappointments, not getting too emotionally drained and at the same time continuing to be as motivated and passionate about each and every next patient.

## The more you learn – the more you want to learn

The more I learned along the way, the more questions I had. It felt to me as though I could do much more to improve the investigation. I could work at both a vet's and physician's office and then add my personal opinion, thoughts and experience to the investigation. I could further expand the project by making posters or a movie about the similarities in treatments, specialization and include more pictures as I am very interested in this topic too.

I could also expand the questionnaire and add questions to find out more about the differences of practicing veterinary or human medicine in different parts of the world (Africa, Asia...). The only problem would be to get in touch with vets and doctors in these countries because I do not know whether they speak English, German or French and whether they would be willing to give such information to a perfect stranger like myself.

Another question I could do researched on is whether different countries have different requirements for getting a veterinary license and what these requirements are.

Well, I guess all of that many more questions are a good sign. The topic still fascinates me and my personal research certainly does not stop with this personal project.

Overall I can say that in the amount of time I had I collected a lot of trustworthy information to further build a valuable foundation for my future.

7

AUG 0 2 2006

Roger Kline's
OFFICE

Jessee LePorin

From: Mary_Keane@mckinsey.com on behalf of Roger_Kline@mckinsey.com

Sent: Monday, July 31, 2006 6:05 PM

To: indra.nooyi@pepsico.com; william_mcdonough@ml.com; jleporin@kmaglobal.com

Subject: Policy Implications of Intellectual Property

At last night's wonderful gathering, Indra mentioned a concern about intellectual property being developed in India, China, etc., to the possible disadvantage of the U.S. (At least I think she did.)

I thought you should know about a recent paper by Amar Bhide at Columbia which argues that innovations originating in one country don't disadvantage other countries since:

1. Almost all the value of an innovation accrues to the user not the innovator

2. The ability to make an innovation useful (i.e., practical and accepted), not the innovation per se, is what creates the value

These factors explain why the U.S. has had substantial increases in productivity in spite of erosion of its leadership in innovation.

Amar's paper is attached.

Great seeing you.

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7/31/2006

Venturesome Consumption, Innovation and
Globalization

Paper for a Joint Conference of CESIFO and Center on Capitalism and Society
"Perspectives on the Performance of the Continent's Economies"

Venice, 21 - 22 July 2006

by Amar Bhidé*

**1. Introduction**

The "techno-fetishism and techno-nationalism" described by Ostry and Nelson in 1995 has apparently drawn strength over the last decade from concerns in the West about globalization. The mindset incorporates two related tendencies. One is the focus on the upstream development of new products and technologies while glossing over their downstream consumption and use. The other is the belief that national prosperity requires upstream international *leadership* in upstream activities – "our" scientists, engineers, entrepreneurs, and firms have to be better than everyone else's – they must write more papers, file more patents and successfully launch more products. Otherwise, competition from low-wage countries like China and India will erode living standards in the West especially as they upgrade their economies to engage in more innovative activities.

In this paper I claim that the two tendencies misapprehend the nature and role of
innovation as well as the implications of globalization. I argue that the willingness and
ability of individuals to acquire and use new products and technologies is as important as
– and in small countries more important than – the development of such products and
technologies. Moreover nations – unlike many individuals and organizations – don’t
have to outperform ‘competitors’ in order to prosper. Notwithstanding the rhetoric about
the competitive advantages of nations – a transplant from the domain of inter-firm rivalry
that has displaced references to old-fashioned comparative advantages – countries are not
locked into zero-sum trade. An innovation originating in one country does not
impoverish other countries. Rather it tends to improve standards of living in all countries
that have the downstream capacity to acquire and implement the innovation.

My concern with the neglect of the consumption and use of innovation, (and the policy
implication thereof) dates back to 1982. As an employee of the consulting firm,
McKinsey & Co., I was working on a study to help the European Union promote the
Information Technology industry. The focus of the study was entirely on what the EU
could do to help the producers of IT equipment through grants, subsidies and tax breaks.
My efforts to broaden the scope to include the behavior and needs of the users of IT were

* Glaubinger Professor of Business, Columbia University, and member of its Center on Capitalism and Society.
Contact at bhide@columbia.edu. The latest version of this article is posted at www.bhide.net/publications.html

I am grateful to the Kauffman Foundation for funding the field study from which the ideas for this paper have emerged, to Elizabeth Gordon, the Research Associate on the study, and to Massimo Cordella who provided outstanding assistance for this paper.

July 10, 2006

futile. I was the lowest ranking consultant on the team, and the clients on the EU side had no interest. *A Harvard Business Review* article (Bhidé 1983) about the importance of the nature of the demand for innovative products that I then wrote had similarly negligible impact.

My perspective has subsequently been informed by my studies over the last 18 years of new and emerging businesses that for convenience we may call “entrepreneurial” firms. Numerous research associates, students and I have examined, in varying depth and detail, more than five hundred such firms. These studies, including notably, an on-going study of U.S.-based venture-capital backed firms', suggest that few entrepreneurial ventures – including those characterized as high-tech – undertake cutting edge, “upstream” R&D. Rather, they combine (often not in particularly revolutionary ways) and distribute innovations generated by upstream individuals and firms; to borrow terminology from the computer industry, they play the role of “system integrators” or “value-added resellers.” Accordingly their success – and their much vaunted contribution to productivity – requires not just an ample supply of innovative inputs; entrepreneurial firms also require venturesome and resourceful customers – many of whom are not in the high tech sector – who are willing to take a chance on their products and services. Moreover, entrepreneurial firms do not combine and “add value” just to domestic innovations; in an era of growing cross-border flows of ideas and knowledge, the sources of their innovative inputs are increasingly global. Therefore an increased supply of innovative inputs from abroad is a boon, to the entrepreneurial firms, their customers and to the broader economy.

Although I have derived my perspective mainly through an inductive process for my field research, a review of the literature shows that many of its components are not novel. I will report the linkages as I go along. Here I will mention the especially noteworthy items of prior art that my perspective integrates with or has unwittingly re-discovered.

A close relationship between technology adoption and economic development has been examined by several economic historians. These include Morrison (1966), Rosenberg and Birdzell (1986) – who argue that the West grew rich first because the resistance to adopting new technologies was weaker there – and Mokyr (1990). I use contemporary examples to argue that technology adoption continues to play a critical role.

This paper also repeats Carter and Williams's (1964) caution, of more than four decades ago, that "it is easy to *impede* growth by excessive research, by having too high a percentage of scientific manpower engaged in adding to the stock of knowledge and too small a percentage engaged in using it. This is the position in Britain today." Similarly, in 1986, Paul David wrote that innovation had become a "cherished child, doted upon by all concerned with maintaining competitiveness... whereas diffusion has fallen into the woeful role of Cinderella, a drudge like creature who tends to be overlooked when the summons arrives to attend the Technology Policy Ball."†

* As of this writing, Liz Gordon and I have interviewed the CEOs of 78 such firms out of a target of 100.
†David repeated this observation at a 2003 conference held in memory of Zvi Grilichches when he wrote that "the political economy of growth policy has promoted excessive attention to innovation as a

July 10, 2006

My argument incorporates country and firm level differences in “absorptive capacity” for innovations. The term “absorptive capacity” has been used in the economic development literature since at least the early 1960s to refer to the limited capacity of backward countries to put new investments (and the innovations they may embody) into productive use. Cohen and Levinthal (1989) applied the term “absorptive capacity” to refer to the ability of individual firms to effectively absorb new technologies, and their usage has now become commonplace. But, although their definition is broad, Cohen and Levinthal and subsequent researchers focus mainly on high tech firms, examining for instance how their internal R&D efforts help firms use research produced in university labs.

In examining how absorptive capacities matter, I pay more attention to organizations that don't have any formal R&D efforts and to individual consumers. I also suggest that the use of innovations, like their generation, has disorderly entrepreneurial facets, such as the willingness to confront Knightian certainty. This venturesome consumption of innovations, like their venturesome production falls outside neo-classical models and (unlike R&D spending) eludes objective measurement.

Lastly, the construct of an “innovation system”, comprising many related but different components (instead of a single innovator or a swarm of similar innovators) provides me with a useful expositional device. The idea of a system popularized by Richard Nelson and other scholars accurately reflects how modern innovation really works. Researchers however tend to focus on the upstream elements of the system and their linkages, for instance between university researchers and commercial R&D labs. I will include in the system, the users of innovations, who are far removed from university labs and have no internal research programs.

*Structure.* The next section provides contemporary examples of the techno-nationalistic view that prosperity requires leadership in innovative activity and suggests that such views are incongruent with the failure of per capita incomes in Europe and Japan to catch up with per capita incomes in the U.S.

The four sections that follow discuss important features of modern innovation that are at odds with the assumptions embedded in the techno-nationalist view: Section 3 argues that innovations aren't always destructive – so an innovation abroad doesn't necessarily injure businesses at home. Sections 4 and 5 suggest that, contrary to the upstream-centricity of the techo-nationalists, innovation is the result of a multi-period, multiplayer game, in which the mid and downstream players also play significant 'entrepreneurial' roles. Section 6 suggests that when users of innovations are sufficiently entrepreneurial, they secure most of the benefits, regardless of where the upstream producers might be located.

determinant of technological change and productivity growth, to the neglect of attention to the role of conditions affecting access to knowledge of innovation and their adoption." (David 2003). In that paper David also remarked that Griliches's work first on the diffusion of technology and then on the sources of growth of total factor productivity had been path-breaking, yet Griliches had not pursued the connections between the two. Instead, in his later work Griliches had focused on the "upstream", sources of productivity growth, namely R&D efforts and patenting.

July 10, 2006

Section 7 argues that its mid- and downstream strengths help explain why the U.S. continues to enjoy higher per capita incomes than Europe and Japan, in spite of the alleged erosion in its upstream technological leadership.

The last two discuss the implications for public policy. Section 8 suggests that beyond some basic conditions such as education, the underlying causes of venturesome consumption are elusive. In Section 9 I argue that this elusiveness makes it difficult to construct a policy package to promote the use of innovations, especially on a case by case basis. Rather, I suggest that governments should focus on eliminating the general biases, implicit in a variety of policies that favor upstream innovators over mid- and downstream users.

## 2. A pre-occupation with leadership

Writing at a time when the U.S. was concerned about the "productivity slowdown" and the threat supposedly posed by Japanese manufacturing pre-eminence, David (1986) observed that "success" in the U.S. was "equated with "leadership"... with pioneering on the technological frontiers. To be an assiduous "follower," seems somehow to have acquiesced in defeat, abandoning adventure for the haven of routine"

Concerns about Japan have receded in the last twenty years but the pre-occupation with technological leadership remains well-nourished by rapid growth in China and India. In "America's Technology Future at Risk" Prestowitz (2006a) writes: "American wealth, economic growth and national security have long been based on technological leadership... [T]he United States has always focused on new technology as the main engine of economic welfare. For more than half a century America's broad technological leadership has been unchallenged."

Prestowitz is especially concerned about the U.S. position in the telecommunications industry, which "has long been an indispensable element of America's technological leadership and economic success." Now however, the U.S. is "well on its way to surrendering leadership in advanced telecom products and services". Prestowitz points to several other alarming developments: In 2005 the US had a "$55 billion trade deficit in Advanced Technology Products." Venture capitalists are "pressing the start-up firms they finance to move R&D to Asia...Many telecom and technology companies [have] cut vital R&D spending by 10-40%. At the same time, Government R&D spending in these areas has also fallen by over 30%."

"Foreign companies make up the majority of the top ten recipients of U.S. patents each year and the United States has fallen behind the EU and lost ground to Asian countries in the publication of scientific articles. The United States is awarding fewer Bachelor of Science degrees than it did in 1985 and far fewer than Japan, the E.U., China, India and even Korea."

The economist Richard Freeman uses different arguments than does Prestowitz (a former businessman and trade negotiator in the Reagan Administration who now runs a think-tank he founded) but reaches similar conclusions. Freeman's (2005) NBER working paper, like Prestowitz's article asserts the significance of leadership: 'leader' or 'leadership' appears in the title and five times on just the first page of the paper. Shorn,

4

July 10, 2006

perhaps unfairly, of their qualifying clauses and sentences, Freeman's concerns can be stated as follows.

"Leadership in science and technology gives the US its comparative advantage" and "in a knowledge based economy, contributes substantially to economic success."

Unfortunately for the U.S, its "global economic leadership" is under threat. "Changes in the global job market" are "eroding US dominance in science and engineering". Freeman forecasts that "the erosion will continue into the foreseeable future". By "increasing the number of scientists and engineers, highly populous low income countries such as China and India can compete with the U.S. in technically advanced industries" and "undo the traditional "North-South" pattern of trade in which advanced countries dominate high-tech while developing countries specialize in less skilled manufacturing."

The evidence that Freeman offers to support his claim that U.S. dominance in science and engineering is and will continue to erode includes the following: In 1970, "over half of science and engineering doctorates were granted by US institutions of higher education." Since then, the U.S. share has steadily declined. As shown in Table 1a, countries in the European Union produced 7 percent fewer PhDs than the U.S. in 1975. By 2001 EU institutions granted 54% more PhDs and by 2010 they would probably grant nearly twice the number of PhDs as U.S institutions. Japanese institutions produced just 11% of the PhDs produced by U.S. institutions in 1975. By 2001 that percentage had more than doubled, to 29%. China produced virtually no doctorates in 1975. By 2001 it was producing nearly a third as many as the U.S. and by 2010 it was expected to produce more doctorates than the U.S. Overall, according to Freeman's projections, the U.S. share of world's science and engineering doctorates is likely to fall to about 15% in 2010.

Like Prestowitz, Freeman points to the fall of U.S. shares of scientific publications, patents, and bachelor in engineering degrees and the expansion of R&D establishments in Asia. "Data on publications and citations by country of investigator show that the US predominance has already begun to drop" writes Freeman. "In spring 2004, the front page of The New York Times reported a fall in the U.S. share of papers in physics journals while Nature reported a rise in the share of papers in China. The NSF records a drop in the US share of scientific papers from 38% in 1988 to 31% in 2001 and a drop in the US share of citations from 52 percent in 1992 to 44 percent. The share of papers counted in the Chemical Abstract Service fell from 73% in 1980 to 40% in 2003."

"Many high-tech companies" continues Freeman "have begun to locate major research installations outside the U.S. In 2004, the CEO of Cisco declared that "Cisco is a Chinese company" when he announced that the firm was setting up its newest R&D facility in China. One of Microsoft's major research facilities is in Beijing. OECD data shows a large increase in U.S. outward R&D investment from 1994 to 2000....As of mid 2004, the Chinese government registered over 600 multinational research facilities in the country, many from large US multinationals. By contrast, in 1997 China registered less than 50 multinational corporation research centers."

The concerns of Prestowitz, Freeman and others have apparently resonated with the U.S. Administration. Noting the "uncertainty" engendered by "new competitors, like India and China" President Bush, in his 2006 State of the Union Speech, announced the "American Competitiveness Initiative" that would (according to a White House Press release) "help the United States remain a world leader in science and technology." The

5

July 10, 2006

initiative included proposals to double the Federal commitment to "critical basic research programs in the physical sciences"; make permanent the research and development tax credit (to encourage "bolder private-sector initiatives in technology"); and support universities that "provide world-class education and research opportunities."

Policy makers in other advanced countries also apparently subscribe to the thesis and employ similar arguments and rhetoric. In the U.K., the Chancellor of the Exchequer Gordon Brown's 2006 Budget Statement noted that China and India had "4 million graduates a year to Britain's 400,000" as well as more computer scientists and engineers. "Every advanced industrial country knows that falling behind in science" he said "means falling behind in commerce and prosperity." He proposed that the government "do more to support the dynamism and enterprise of business...start[ing] with the importance of Britain leading in scientific invention and discovery." Measures announced in the budget included increasing expenditures on scientific discovery, simplifying allocation of research funding for universities and expanding the scope of R&D credits.

The 'Lisbon Agenda' of the European Union commits to raise research spending in EU countries to at least 3% of GDP. According to a European Commission web-site devoted to the agenda, "the EU invests less of its GDP in research and development than its main competitors" – just 1.96% of its GDP compared to 2.59% for the U.S., 3.12% for Japan and 2.91% for Korea. And Europe "does not have enough scientists and researchers – 5.3 per 1000 workforce compared to 9 per 1000 in the U.S. and 9.7 per thousand in Japan." The proposed solutions to the shortage of scientists include creating a "European Institute of Technology" and making "science a more attractive career option."

The EU and Messrs. Prestowitz and Freeman can't both be right about whether or not the U.S. is 'behind' Europe. But putting that aside, why does scientific and technological *leadership* matter to a country or region in the first place? For Prestowitz, the historical correlation of U.S. leadership with prosperity makes it self-evident that any erosion of leadership must impair standards of living.

The economist Freeman relies on models of "North-South" (or rich country-poor country) trade to reach this conclusion. Freeman's reasoning may be paraphrased as follows:

1. In highly simplified classical or neo-classical models, trade always benefits both parties; but when complications like first mover advantages or increasing returns to scale are introduced, the models show that gains to one country may come at the expense of another.

2. Trade models also predict that technological advances in a country may help – or hurt – its trading partners depending on the sector in which they occur. In particular "a country benefits when a trading partner or potential trading partner improves technology in a sector in which the country does not compete but loses when a country improves its technology in country's export sector. It is good for Alaska if El Salvador improves its technology for banana production but bad for Nicaragua."

3. North-South trade is mutually beneficial when "the South competes with the North for production of older products through low wages but is unable to compete in the newest technology." If however, the South starts competing with the North in "the high-tech vanguard sectors that innovate new products and processes" the South gains at the

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expense of the North. Thus as China increases its supply of scientific and engineering
workers and competes with the U.S. for upstream innovations instead of just trinkets and
toys, the U.S. begins to lose rather than benefit from trade. ("The loss of comparative
advantage can substantially harm an advanced country", writes Freeman.)

Freeman acknowledges that there are models which show that "under some
circumstances the loss of technological advantage *could* benefit the advanced country".
But Freeman dismisses such a scenario as "more of a theoretical curiosum than a realistic
representation of the current economic world." In Freeman's judgment, the "loss of
technological superiority overall is likely to be disastrous for US workers and firms."
Trends like the "multinational movement of R&D facilities to developing countries are
harbingers" of the difficult "adjustment problems" that await U.S. workers.

But recall Freeman's evidence about the loss of U.S. shares in scientific publications, citations and patent counts. Look again at the data in Table 1 on the ratios of scientific and engineering (S&E) PhDs. Towards the end of his article Freeman says that the increase in S&E workers in Europe and Japan is "recent" whereas the table points to a trend that has been in place for more than two decades. Richard Nelson and Gavin Wright wrote about "The Rise and Fall of American Technological Leadership" in 1992. Table 1b shows there has been no decline in U.S. per capita incomes in either absolute or relative terms. PPP-adjusted per capita income in EU countries was about 75% of per US per capita income in 1975 and the gap has remained more or less at that level since then. Japanese per capita incomes reached 80% of the per capita incomes in the U.S. by 1989; after that, relative incomes in Japan have actually fallen a bit. According to 'convergence theories', European and Japanese incomes should have been catching up with U.S. incomes anyhow; with substantially increases in their share of PhDs, scientific articles and the like, why didn't Europe and Japan roar ahead? Why instead was the growth rate in output per hour over 1995-2003 in Europe was just half that in the United States (Gordon 2004)?

Japan's reconstruction and export led boom for nearly four decades after the Second World War also doesn't sit well with Freeman's account. As is well known Japan grew at miraculous rates as it moved, to use the language of the trade models, from the 'South' to the 'North' and the composition of its exports changed from low end trinkets to cutting edge goods. U.S. per capita income and productivity which started at a much higher base did grow more slowly than Japan's but grow they did. Indeed prosperity increased in most Western countries, all of whom could not possibly have been leaders in science and technology.

What accounts for the gap between the 'technical leadership is a must' assertion on the one hand and many decades of experience on the other? Are Freeman et. al. measuring leadership inappropriately? Or does the problem lie with the models? In the sections that follow, I argue the latter. Although the mathematics behind the models may be sound and industrious researchers may even provide evidence that is consistent with their predictions, to reach the conclusions suggested by Freeman is like walking over a bridge whose design ignores the force of gravity. In the sections that follow I suggest that the North-South models invoked by Freeman omit or mischaracterize vital features of the modern innovation system, especially the role of the users.

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### 3. Non-destructive creation.

Just as a devout Hindu might begin a journey with a prayer to the Lord Ganesh, it is obligatory to start a discussion on modern innovation by invoking Schumpeter. The thousands of pages he wrote over more than four decades contained sharp, unequivocal claims as well as tangles of contradictions: Elster (1993) describes Schumpeter as an 'elusive' writer who could contradict himself in the course of a single paragraph. Nevertheless, as Rosenberg (1976) puts it, "his model has become the accepted one for all innovative activity". Even the North-South trade theories which are neo-classical rather than 'Schumpeterian' incorporate the key elements. I do not question Schumpeter's overall thesis – that innovation drives long term growth – but, in my view, the model itself (or at least the common conceptions thereof) has elements that are inconsistent with the realities of the modern innovation system.

First, consider Schumpeter's (1961) assertion that "a perennial gale of creative destruction" is an "essential fact about capitalism. It is what capitalism consists in and what every capitalist concern has got to live with." Destruction is the price of innovation: the automobile must displace the buggy makers and mass merchandisers must put the country store out of business. The innovator combines the roles of the mobs of the French revolution who overthrew the *ancien regime* and Napoleon who founded an empire on its remains.

Destructive creation is also central to the predictions of the North-South models that if the South starts to innovate, incomes in the North will be reduced" for the Southern innovator to win, its Northern competitors have to lose. The old cannot co-exist with the new.

Many innovations *do not* in fact displace existing products and services because they create and satisfy entirely new wants.* Indeed, this non-destructive creation represents a critical complement to creative destruction for the following reason: Long run economic growth of course requires productivity growth. But productivity growth doesn't just come from improved efficiency - using fewer resources to satisfy our current wants. The creation and satisfaction of new wants can also increase per capita output. For instance, an artist may increase her productivity by developing new techniques that speed up her output of paintings. Alternatively, she may develop a new oeuvre that commands higher prices. She may produce exactly the same number of canvases as before, but, provided her work sells at higher prices, her *economic* output and productivity increases. Moreover, the new oeuvre may serve as a substitute for more traditional paintings, so innovator's productivity gain comes at the expense of the productivity of artists' who face reduced demand. But it doesn't have to: the new oeuvre may appeal to completely new sensibilities and find a place on walls that otherwise would have remained bare.

In fact, economies cannot sustain increases in productivity and living standards simply through increasing efficiencies in the satisfaction of existing wants. In the short run, increased efficiencies reduce costs and as costs decline, people consume more of the good or service. But eventually, the law of diminishing utilities sets in. Sated consumers refuse to buy more even if prices continue to decline. After that, further increases in efficiencies reduce the demand for labor.

* The following is a condensed version of a prior lecture (Bhidé 2004).

July 10, 2006

In principle, societies could accommodate the reduction in the demand for labor by increasing everyone's leisure. Over the last century, economic growth has helped reduce working hours and increase vacations. But somehow, beyond a certain point, societies seem unable to accommodate reductions in the demand for labor by spreading the work around. Efforts to control unemployment by mandating reductions in work weeks or increasing the number of holidays don't seem to work.

Rather, it is the entrepreneurial activity of creating and satisfying new wants that keeps the system humming. It employs the labor and purchasing power released by increased efficiencies in the satisfaction of old wants. It also creates incentives for continued increases in efficiencies even after demand for old wants has been fully satisfied: Producers who satisfy old wants have to keep economizing on their use of labor because they must compete for employees (and share of consumers' wallets) with innovators who satisfy new wants.

The historical record shows that the great prosperity brought about by the Industrial Revolution – incomes more than doubled in the 19th century and increased more than eightfold in the 20th century – has both destructive and non-destructive roots. Innovations such as tractors, threshing machines, fertilizers, pesticides and hybrid seeds led to vast improvements in agricultural productivity. As productivity increases reduced costs and increased the affordability of food, per capita consumption grew. But the increase in the consumption of food or other existing goods doesn't come close to accounting for the vast increases in overall per capita G.D.P. According to William Nordhaus's (1997) estimate less than 30% of the goods and services consumed in 1991 bear much resemblance to the goods and services of the late 19th century. "Most of the goods we consume today" Nordhaus writes, "were not produced a century ago. We travel in vehicles that were not yet invented that are powered by fuels not yet produced, communicate through devices not yet manufactured, enjoy cool air on the hottest days, are entertained by electronic wizardry that was not dreamed of and receive medical treatments that were unheard of."

Some of the new goods replaced the goods consumed by our forebears. Cars and buses replaced horses and stagecoaches. Steamships grounded sailing ships and ready-to-eat cereal pushed homemade porridge off breakfast tables. But many new 20th century products created new markets and satisfied new wants. They were like a new oeuvre of art purchased for spaces that would otherwise remained bare. Air-conditioners reduced temperatures in previously un-cooled factories stores and office buildings. Airplanes did not reduce the demand for automobiles – people flew when they would not have driven. New drugs and vaccines offered cures for diseases for which treatments did not previously exist. In 1938, the New York Times observed that the typewriter was "driving out writing with one's own hand," yet Petroski (1990) reports the sale of 14 billion pencils in 1990.

Moreover even those apparently destructive new products also created new markets because they had features that the products they displaced did not. For instance, automobiles provided much faster and not just cheaper transportation than did horse carriages, so people could live in spacious houses located at some distance from their workplace. This helped create demand for suburban housing that did not previously

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exist. Similarly incandescent lamps didn't merely replace candles and kerosene lamps: their intense luminosity helped create a market for cricket and baseball played at night.

The innovations in digital and information technology of the late 20th century have followed the same pattern as the electro-mechanical innovations of earlier decades. The innovations have certainly involved some substitution. For instance, calculators displaced slide rules, micro-processor based workstations displaced mini-computers and CDs displaced cassette tape recorders. But, there has also been at least as much non-destructive creation. The personal computer (PC) did not blow away the traditional mainframe computer in a gale of creative destruction. The PC's killer application, the spreadsheet, did not displace any existing mainframe based applications. Rather it allowed users, many of whom had not previously used computers extensively, to perform analyses and simulations which they would not have otherwise performed. Similarly the enormous growth of the home market for PCs did not reduce the demand for mainframe computers.¹

New communications services – E-mail, newsgroups, and “chat” – provided a critical mass of users for the Internet. These services apparently did abate the demand for traditional phone lines in the U.S. – U.S. cities continue to require new area codes. And those new products that displaced old products did so *after* they had created a new market. For instance as I discovered in the course of a consulting study for a now defunct typewriter manufacturer, shipments of word processing units increased fourteen-fold growth between 1977 and 1981. But because word processors increased primary demand by satisfying some hitherto unmet want, the sales for typewriters in the United States remained steady at around a million units a year during this period. Similarly, one day (after standards and coverage issues have been resolved) cell phones may make land line phones obsolete. But not before consumers have purchased hundreds of millions of units in applications where land line phones had not been used.²

Assuming that this historical pattern in maintained, if the countries of the South start innovating, some of their innovations may destroy existing businesses in the South. Or they may simply increase the basket of goods we consume and absorb the labor and purchasing power that is constantly being released by improved efficiencies in the production of old goods.

## 4 Many periods, many players

According to Schumpeter – and, implicitly, in the North-South models – noteworthy innovations are carried out in one-shot, by one innovator. This precludes the development of innovations though the efforts of multiple players located in different places and contributing at different times. But, as we will see in the section below what's precluded by the Schumpeterian and North-South models is in fact a central feature of modern innovation.

### *An evolutionary process*

According to Schumpeter, the economically significant innovations that disturbed the “circular flow” were ‘large’ and ‘spontaneous’ rather than ‘small’ and ‘adaptive’. They so displaced the “equilibrium point” that “the new one [could] not be reached from the old one by infinitesimal steps. Add successively as many mail coaches as you please, you

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will never get a railway thereby." Schumpeter also distinguished such innovations ("carrying out of new combinations of the means of production") from their antecedent inventions. "The making of the invention and the carrying out of the corresponding innovation," he wrote, "are, economically and sociologically, two entirely different things." (Schumpeter 1939) Inventions are "economically irrelevant" as long as they are not carried out into practice (Schumpeter 1934).

In his 1976 book, *Perspectives on Technology*, Rosenberg makes a persuasive case for an incremental process, involving on-going rather than one-off inventive activity. Rosenberg writes that Schumpeter created "artificial conceptual disjunctions between innovative activity and other activities with which it is not only linked, but which in fact constitute major parts of the historical process of innovation itself." This leads us to "focus disproportionately upon discontinuities and neglect continuities in the innovative process" and to overlook its crucial later stages.

The inventive activity which precedes a new combination in Schumpeter's model, observes Rosenberg, is "carried on offstage and out of sight. Inventions come onto the Schumpetarian stage already fully grown" and ready for commercial exploitation. In fact, we cannot easily distinguish between invention and innovation: "Whereas for some inventions no serious technical obstacles to their implementation may exist once the basic idea has been established, for other inventions such obstacles are formidable and can be overcome only after much further time consuming search and experimentation."

Rosenberg questions the association of inventions with the "initial basic conceptualization of a product or process," under the assumption that "as soon as the basic conceptual or intellectual breakthroughs have been made, all the "real" problems are solved." Writes Rosenberg: "To date the invention of the fluorescent lamp in 1859, the gyro-compass in 1852, the cotton picker in 1889, the zipper in 1891, radar in 1922, the jet engine in 1929, or xerography in 1937 is to select years in which significant steps were indeed made. But in none of these years was the product concerned even remotely near a state of technical feasibility." Solving the problems that remain after the initial conceptualization takes "protracted inventive activity." Techniques for producing a new material (such as polyethylene) under laboratory conditions may be known, but it may take years to develop ways to produce it commercially. Or, an invention may be technically feasible, but its economic superiority over existing techniques may require many improvements in its "performance characteristics, often in inconspicuous and unspectacular ways." Early diesel engines for instance were too heavy for economic operation, and early jet engines had unacceptably low performance characteristics until the development of materials that could withstand high pressures and temperatures. In such cases, innovators cannot, per the Schumpeter model, merely select inventions which are "already suitable for commercial introduction" and carry out the introduction of a new production function with them. (Rosenberg 1976 p. 72-73)

Rosenberg similarly questions the distinct and secondary role Schumpeter accords to the propagation of new combinations. Schumpeter posits a "sharp disjunction" between "the high level of leadership and creativity involved in the first introduction of a new technique as compared to the mere imitative activity of subsequent adopters." In fact, Rosenberg argues, the diffusion of an innovation requires much more than simple imitation. A "stream of improvements in performance characteristics," "progressive

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modification and adaptation" to suit the requirements of sub-markets, and the
introduction of complementary inputs, "decisively affect the economic usefulness of an
original innovation." These ongoing activities are:

...central to the pace of the diffusion process. It is economically absurd to consider the innovation of the automobile as having been accomplished when there were a few buffs riding around the countryside terrifying horses. Innovation is, economically speaking, not a single well-defined act, but a series of acts closely linked to the innovation process. An innovation acquires economic significance only through an extensive process of redesign, modification, and a thousand small improvements which suit it for a mass market, for production by drastically new mass production techniques, and by the eventual availability of a whole range of complementary activities, ranging, in the case of the automobile, from a network of service stations to an extensive system of paved roads. These later provisions, even if they involve little scientific novelty, or genuinely new forms of knowledge, constitute uses and applications of knowledge from which flow the productivity improvements of innovative activity.

A host of other innovations introduced in the years after Rosenberg's 1976 book involve
continuous rather than one shot innovation. Consider the evolution of microcomputers after
1975 - the year in which the pioneering Altair was introduced. The current generation of
laptops and desktops, which provides more processing power and functionality than did the
computer center of my undergraduate engineering college, has come a very long way from
the Altair. Altair aficionados derived less practical use from their machines than did the
turn-of-the century automobile buffs. Lacking basic input or output devices (such as
keyboards and printers) Altair's could not even scare horses. Numerous innovations turned
this oddity into a ubiquitous artifact. Some of these innovations - the mouse, graphical
user interfaces, and electronic spreadsheets - represented conceptual breakthroughs.
Others (such as word-processing software) were borrowed from mainframes and
minicomputers.

Continuous improvements and refinements in performance and features have been a
hallmark of the industry -- Excel 2003 has come a long way from the first spreadsheet,
Visicalc. Complementary innovations have played a crucial role in such improvements:
Excel 2003 could not have been implemented on earlier generations of hardware. The
introduction of new microprocessors, storage devices, application and operating system
software, communications technologies (such as local area networks and the internet),
innovations in manufacturing and distribution (such as the "build to order" process) and the
opening of new market segments (such as home computing) have reinforced each other and
sustained a virtuous cycle of ever improving price-performance.³

Although Rosenberg defers to Schumpeter's analysis for "major innovations" involving "significant shifts to an entirely new production function" he does not provide examples of such one shot breakthroughs. In fact, I can't think of any. Even ventures like Federal Express that started with a revolutionary concept required refinement over several years before they attained commercial viability (Bhidé 2000)

*Massively multiplayer game*

Schumpeter placed the individual entrepreneur at the center of the innovative process in his
early work, but later claimed that the large corporation would inevitably usurp the

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entrepreneur's role. His 1911 book, *The Theory of Capitalist Development* credited capitalist innovation to entrepreneurs with the 'dream and will to found a private kingdom' and the 'will to conquer.' The 1934 work, *Capitalism, Socialism and Democracy* placed kingdoms ahead of conquerors. In creating the giant enterprise, Schumpeter now declared, entrepreneurs had eliminated their own function. The "perfectly bureaucratized giant industrial unit" could automatically discover and undertake the 'objective possibilities' for innovation. It had "come to be the most powerful engine of progress."

Schumpeter's claim is said to be one of the most extensively tested in the field of economics but with inconclusive results. The studies (reviewed in Acs and Audretsch 1991) typically rely on two types of indirect measures: R&D expenditures and patent filings. Studies of R&D spending, according to Scherer (1983) "tilt on the side of supporting the Schumpeterian hypothesis that size is conducive to vigorous conduct of R&D" whereas the evidence on patents "leans weakly against the Schumpeterian conjecture that [large companies] are especially fecund sources of patented inventions."⁴ The results can have "two rather different interpretations: that the largest firms in an industry generate fewer patentable inventions per dollar of R&D than their smaller counterparts, or that they choose to patent fewer inventions (Scherer 1983)."

Around the time of the 1999-2000 internet bubble, the 'Silicon Valley', venture-capital backed model of the firm was popular among management gurus and academic researchers. In a 1999, Gary Hamel *Harvard Business Review* article exhorted large companies to "bring Silicon Valley inside." Kortum and Lerner's "Assessing the contribution of venture capital to innovation" was published in the *RAND Journal of Economics* in 2000. Using a variety of methods, but then "focusing on a conservative middle ground" Kortum and Lerner estimate that "a dollar of venture capital appears to be three times more potent in stimulating patenting than a dollar of traditional corporate R&D" suggesting that "venture capital, even though it averaged less than 3% of corporate R&D from 1983 to 1992, is responsible for a much greater share — about 8% — of U.S. industrial innovations during this decade." After the bursting of the internet bubble however, the VC-backed model has apparently lost some of its luster and there has been no major redeployment of research resources in its direction.

In my view, the Schumpeterian hypothesis and the empirical research it spawned misses the point. Different types of organizations produce different and often complementary innovations; therefore comparisons of their contributions can mislead. The distinctive contributions of large and small companies have in fact been discussed by many authors including Arrow (1982), Winter (1984) and Acs and Audretsch (1991).⁵

In my previous work (Bhidé 2000 and 2006) I have discussed the comparative advantages of firms not just based on their size but also according to the source of their financing: the public markets, professional venture capitalists, angel investors and self financing by entrepreneurs in undertaking initiatives with different capital requirements and novelty.⁶ My on-going research also suggests important differences between the kind of R&D undertaken by VC-backed businesses and by the labs of large companies. VC-

* I argue that at one end publicly financed firms can undertake large projects but have a relatively low tolerance for Knightian uncertainty of highly novel initiatives. At the other end, the self-financed entrepreneur tends has a comparative advantage in undertaking projects that are in a broad sense of the word, highly novel.

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backed businesses undertake relatively quick and dirty projects and don't employ many researchers with advanced degrees. And, they often use the innovations coming out of large company and university research efforts.*

The broad categories of firms and financiers that I have mentioned themselves contain heterogeneous organizations. VCs can vary in their target investment amounts and capacities and in their preferences for early or later stage investments. Some provide funding to biotechnology firms on the scientific frontier; others provide the coffee retailers Starbucks with the capital needed for geographic expansion. Similarly some self-financed entrepreneurs help shape completely new industries, as Paul Allen and Bill Gates did in 1975. Others create new supply chains and distribution systems after the product category has come of age, as did the company Michael Dell started in 1982 in the computer industry. Non-profit organizations like university research facilities, also contribute to the process of innovation – and in quite different ways. Some undertake basic research whose commercial value, if any, is very indirect; others favor projects with an eye to licensing the intellectual property they develop; and yet others provide a venue for the interactions and tinkering that accidentally result in the start of companies like Cisco and Google.

The innovation system resembles a rain forest rather than a tree farm or, to use a contemporary metaphor, a massively multiplayer on-line game rather than solitaire or chess. It includes a multitude of species (or characters) differentiated along many dimensions, rather than say just by their size or shape, or whether or not they have wings.⁶ Their interactions can be predatory or symbiotic, accidental or deliberate, extended or brief. And, as we will see in a later section, the interactions can extend past national borders.

## 5. Venturesome Consumption

In the North-South trade models – as in all mainstream economic theories – the users of new technologies are at once passive and omniscient. They play no role in the development of innovations; but, once innovations appear users know exactly whether they should buy the offering and what they should pay. In Schumpeter's model too, the innovator is the star, while those who then imitate or modify have secondary parts. Consumers don't appear in the cast at all.

In fact both the neo-classical and Schumpeterian models fail to do justice to the role of users. In a system where innovations are carried out by a multitude of players, except for the end consumers, the producers of innovations are also users of 'upstream' or "adjacent" innovations. Moreover, as I will discuss next, users – including those at the end of the line–often play a venturesome or 'entrepreneurial' functions in leading or participating in the development efforts, bearing 'unmeasurable and unquantifiable' risks and in resourceful problem solving. Therefore, contrary to the up-stream centric-view, the willingness and ability of users to undertake a venturesome part plays a critical role in determining the ultimate value of innovations.

* The basic differences in category may well be responsible for the large difference in the efficiency of patenting efforts reported by Kortum and Lerner and the absence of any significant redeployment of research expenditures after the publication of their results.

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## Contributions to development

MIT's Eric Von Hippel has been the leading proponent of the view that innovation often starts with users, particularly the so-called “lead users” rather than the manufacturers of the product or service. In a 1988 book, which built on his research dating back to the mid-70s Von Hippel reported that users had developed about 80% of the most important innovations in scientific instruments and most of the major innovations in semiconductor processing. In his 2005 book Von Hippel writes that “a growing body of empirical work shows that users are the first to develop many and perhaps most new industrial and consumer products.”

The book recalls Adam Smith's (1776) observation that many labor saving machines were invented by “common workmen” who “naturally turned their thoughts towards finding out easier and readier methods of performing” some simple operation they had been employed to perform. Other historical examples that Von Hippel cites of where most important innovations were led by users include basic machine tools like lathes and milling machines – according to Rosenberg (1976) textile, gun and sewing machine took the lead; oil refining (Enos 1962); and, the most widely licensed chemical processes (Freeman 1969).

In consumer products, Von Hippel provides examples from extreme sports like high performance wind-surfing, snow boarding and mountain biking. High performance wind-surfing started when competitors in traditional wind-surfing events modified standard boards in order to do “jumps.” The modifications were then used in boards used for normal wind-surfing. Similarly, Von Hippel reports that mountain biking started in the early 1970s with young cyclists who put together bicycles, using strong frames, balloon tires, and drum brakes from motor-cycles, for rough off-road use. A fragmented cottage industry then started to supply such cycles for those who didn’t want to assemble their own machines, but it wasn’t until mountain biking had grown to half a million participants before the mainstream suppliers got into the act.⁷

In the ventures that I am now studying (and have previously studied) user led innovation does not appear to be the norm, except in the very broad sense that most innovators do put themselves in the shoes of users. This could be because of an artifact of my samples or because I have not specifically focused on the issue of user-led innovations. Moreover, although user-led innovation has been critical in many instances, it may not be as pervasive as the academic literature suggests: the academic community, like the newspapers can be prone to a “man-bites-dog” type bias – studies of producer-led innovation would not excite interest and so would not be widely undertaken or published.

My on-going study of venture backed-businesses does however suggest an important role for users, even if they don’t initiate or take the lead in developing new products and services. In interview after interview, we were told of the importance of what in the idiom of the industry is known as “customer engagement” with a few potential purchasers – the so-called ‘alpha’ or ‘beta’ users. These users engage in a dialogue with the development team that helps determine the attributes of the product or service that is ultimately sold. For instance, developers may start with the core component of a solution to an important problem faced by potential customers, but in the course of the dialogue with users then learn about complementary functions that must be added to the core to make it work. Or developers may conceive of a product with many functions, but then

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learn that some features add more to the cost of the product than they do to its value. Similarly, customer dialogue can help design an effective "user interface"; as the success of Google's search engine and Apple's Ipod shows, the so-called 'look and feel' of a product can be as important to its utility as the technical features that lie 'under the hood'.

For many of our interviewees, an amorphous agglomeration of the many things learned from their interactions with customers that are incorporated into their products, rather than their core idea, was the most valuable source of their intellectual property. Interestingly, the ownership of patents does not seem to be the norm in our sample or in the VC-backed companies studied by Cockburn and Wagner (2006). Our interviewees claimed that expense of filing patents was not worth it because even if the costs of filing were not very high, the costs of enforcing them would be prohibitive, so there was no point in incurring any filing costs. These claims in conjunction with the nature of the development process suggests that the companies might not have been in a position to file strong patents: the core idea was not particularly novel or non-obvious, while the truly valuable intellectual property, co-developed with customers and embedded in the optimal combination of features, user interfaces and so on, was too amorphous to be captured in a patent.

The contribution of customers to the development process continues after the first full-blown commercial launch. As previously discussed, products can evolve so much over time that the relationship to their antecedents may be all but unrecognizable. Rosenberg (1982) suggests that "learning by using" by customers often plays a significant role in such transformations.

## *Bearing 'unmeasurable and unquantifiable' risks*

According to Knight (1921) the essence of entrepreneurship involves responsibility for 'uncertainty' - facing unmeasurable and unquantifiable risks rather than betting on situations (as in a casino) where the odds have been well established by many prior trials. But it is not just the producers of an innovation who face Knightian uncertainty - purchasers (who may have no role in its development) also cannot form objective estimates of their risks and returns.

One source of uncertainty lies in whether or not the innovation actually does what it is supposed to do. A product that works in the lab or with a few beta sites may not work for all users because of some unexpected difference in the conditions of its implementation. In addition, a product that works fine at the outset may fail later on. An innovation, like a theory, can never be proven to be 'good' - at any moment, we can only observe the absence of evidence of unsoundness. Repeated use of a product may surface hidden defects that cause malfunctions, increase operating costs or pose health and safety hazards to the user or the environment.

Unanticipated technical failures injure both the developers and the users of the innovation. In fact, users may face even greater exposure. In many products and services, failures can cost users many times their purchase price. Defects in a word-processing or email package that costs just a few hundred dollars, may wipe out many years of invaluable files and correspondence. Or even if the data isn't lost, the costs of transferring the files to a new software package - and learning how to use the package will tend to be substantial. Similarly, a defective battery in a laptop can start a fire that

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burns down a house – this did in fact happen to a friend. Tires that wear badly can have fatal consequences. A security hole in its servers can cripple an on-line brokerage, and the belated discovery of the hazards of asbestos can lead to tens of billions of dollars of removal costs.

Consumers' investments in products that work perfectly well for them may also be impaired, if they fail to attract a critical mass of other users. If that happens, vendors (and providers of complementary add-ons) will often abandon the product and stop providing critical maintenance, upgrades and spare parts. Or the vendors may go out of business entirely. This has been a common occurrence in the IT industry. Customers may also be left stranded if upgrades and new releases don't have 'backward compatibility' with their forbears, or if a totally new technology makes old products obsolete.

As mentioned, many innovations seek to satisfy new wants rather than just provide a substitute for existing products. In such cases, customers also face Knightian uncertainty about whether and by how much the value they derive from the innovation will exceed its price. In the schema of neo-classical economics, consumers have a gigantic, well-specified utility function for all goods, extant as well as un-invented. Therefore when an innovation that serves a new want (or a new combination of old wants) appears, consumers consult their utility functions, as they might a tax table, and know exactly what its worth to them. As it happens there is however to my knowledge, absolutely no empirical basis for such an assumption. In fact the evidence from 'behavioral' researchers like George Lowenstein points in exactly the opposite direction: people don't have a clue about the value of things they have not experienced before: when researchers ask subjects how much they would pay for some novel experience, such as kissing their favorite movie star, they receive whimsical responses, anchored to some irrelevant piece of data just planted in the subjects' minds by the researcher, such as social security numbers. One interpretation of these behavioral experiments is that people are irrational; the other is that they simply don't know, and blurt the first thing that comes to mind to earn their $5 for participating in the experiment.

Behavioral research has been criticized for experiments where the subjects, unlike actors in the real world have no stake in the outcome, but in this instance the experiments really do seem to correspond closely to reality. It is highly improbable for instance that anyone who wears glasses or uses contacts has a firm grasp of the economic value of (successful) corrective laser surgery or someone who has a conventional TV set has a good measure of the additional value of switching to the sharper images provided by a digital product. Indeed I am skeptical that people who actually have laser surgery or buy a digital TV set can ever quantify the value. Before or after, the enhanced utility is as much a shot in the dark as the value of the pleasure Lowenstein's subjects anticipate from kissing movie stars. I personally have not seriously considered either laser surgery or buying a digital TV set, but I have been enticed by the 'latest' in personal computer hardware and software for more than two decades. I have no idea of the value of any of any of the numerous upgrades I have experienced (or for that matter, a good estimate of the time and opportunity costs I have incurred in the course of these upgrades.)

Similarly, although I have worried about – and periodically endured – the consequences of technical defects and abandonment of favorite programs by vendors, I have never

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actually made any effort to quantify the probability distributions. I cannot even imagine being able to enumerate all the dire possibilities. Similarly people who have corrective eye surgery may ask about the probability that something might go wrong, so that the operation won't give them 20/20 vision. But what basis could they possibly have for evaluating the consequences twenty or thirty years later? I suspect that most don't even try.

Organizations who purchase expensive systems do often expend many man-years of effort to evaluate the costs and benefits. For example, as of this writing, Columbia Business School is in the process of acquiring a new "courseware" platform. A committee has been formed, long Requests for Proposals have been issued, short lists have been made, vendor proposals have been studied, consultants have been retained .... but for all the effort and the availability of the finest analytical minds for the exercise, the value of the new courseware will remain elusive. The monetary value of enhancing the student satisfaction and learning, saving faculty time and so on can only be a blind guess. Similarly, although the out of pocket costs of purchasing a system will play a role in picking a vendor, the magnitude of the much larger 'all in' opportunity costs (e.g. the time of faculty and staff) of switching to any new courseware platform are unfathomable.

The problem of assessing the costs and benefits of what is now misleadingly called 'Enterprise Resource Planning' (ERP) software is even more acute. According to the current *Wikipedia* entry on the topic, ERP software is used for the "control of many business activities, like sales, delivery, billing, production, inventory management, quality management, and human resources management." The systems are supposed to integrate many functions including "manufacturing, warehousing, logistics, Information Technology, accounting, human resources, marketing, and strategic management." In principle, all these activities and functions are supposed to use a single data-base, rather than, for instance, the Human Resources department and the Payroll department maintaining records on the same employee in two different and incompatible data bases.

Most ERP systems are not built to suit – rather they are based on packages provided by software companies like Oracle and SAP. The premise, according to Eric Roberts (2004) Professor of Computer Science at Stanford is that "software systems are expensive and complex. What's more, the expense of a software system lies almost entirely in its development; once a system is built and tested, the marginal cost of delivering that same system to other users is typically quite small. The concentration of cost in the development phase creates a strong incentive to share development expenses over a large user base. If it costs $10,000,000 to develop a system, it seems foolish for a single institution to bear that cost alone. Given that the bulk of that $10,000,000 represents development, it makes far more sense—at least in theory—for a consortium of institutions to purchase software from a vendor that can then distribute those costs over the community of users."

There is however a catch, writes Roberts: "The success of any enterprise system depends on refashioning the business practices of the institution to match the software rather than trying to change the software to accommodate the idiosyncrasies of the institution. Changing the software violates the underlying economic assumption that allows for the reduction in cost. If each institution tailors the system to suit its needs, the cost advantage vanishes."

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Enterprise software vendors claim that their systems incorporate the best possible business practices. Therefore customers gain significant advantages in refashioning their business practices to fit the standard packages. In fact, although the packages draw their "best practices" from a variety industries and situations there can be a considerable gap between the "best practice" configuration available in the package and the practice that in fact works best for a particular organization. In *The ABCs of ERP* published on-line by CIO Magazine, Christopher Koch writes that:

> While most packages are exhaustively comprehensive, each industry has quirks that make it unique. Most ERP systems were designed to be used by discrete manufacturing companies (that make physical things that can be counted), which immediately left all the process manufacturers (oil, chemical and utility companies that measure their products by flow rather than individual units) out in the cold.

Moreover it is simply infeasible for organizations to adopt all of the specified best practices. Therefore we usually find a compromise: organizations change some of its practices to suit the system, but they also "struggle" to "modify" core ERP programs to their needs. All this makes it extremely difficult to assess the value or the costs. Koch writes that the value of the systems is hard to pin down because.

> ... The software is less important than the changes companies make in the ways they do business. If you use ERP to improve the ways your people take orders and manufacture, ship and bill for goods, you will see value from the software. If you simply install the software without trying to improve the ways people do their jobs, you may not see any value at all—indeed, the new software could slow you down by simply replacing the old software that everyone knew with new software that no one does.

Similarly, there "aren't any good numbers to predict the costs" because:

> [T]he software installation has so many variables, such as: the number of divisions it will serve, the number of modules installed, the amount of integration that will be required with existing systems, the readiness of the company to change and the ambition of the project—if the project is truly meant to be a battering ram for reengineering how the company does its most important work, the project will cost much more and take much longer than one in which ERP is simply replacing an old transaction system. There is a sketchy rule of thumb that experts have used for years to predict ERP installation costs, which is that the installation will cost about six times as much as the software license. But this has become increasingly less relevant ... Research companies don't even bother trying to predict costs anymore.

As is apparent from the discussion above, in many innovations, ranging from corrective laser surgery to enterprise software, the downside faced by users in the aggregated (and sometimes even individually) matches or exceeds the downside of the innovator. Indeed one of the important challenges faced by innovators is to persuade entrepreneurs to take a chance on innovations in the absence of any hard demonstration that the returns are worth the risks. And one of the notable features of the modern innovation system lies in the great many individuals and organizations who are willing to be so persuaded. At the

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dawn of the automobile era only a few very rich buffs served as the guinea pigs. Now the not so well-off use their credits cards – or what they “save” by buying paper napkins in bulk at a Wal-Mart – to take their chances on laser surgery and flat panel TVs without much foreknowledge of the utility their purchase will provide. Similarly large corporations, run by the book with the help of squadrons of financial analysts, will spend tens of millions of dollars on enterprise software based on the crudest of guesses of the costs and the benefits.

## Resourceful Problem solving

Innovators often face situations that require “resourceful problem solving” in the following sense: although the situation may be similar to ones the innovator has faced before, it also contains novel elements, so the innovator cannot simply repeat what has worked in the past. Experience (or “human capital”), which we may think of as the accumulated knowledge of similar past situations helps, but this is not enough. An innovator is more than just a dexterous and knowledgeable surgeon performing difficult but routine arthroscopic knee surgery. The innovator must also act resourcefully in the face of novel situations with a can-do attitude, imagination, willingness to experiment and so on.

Although consuming something novel requires coping with the Knightian uncertainty about its utility, it does not necessarily require resourceful problem solving. Drinking a new soft-drink or showing up for an appointment for corrective surgery is not especially demanding. Other kinds of consumption – such as assembling model airplane may require patience, dexterity and experience but as long as the instructions are clear and complete, do not require resourcefulness or creativity. Indeed creative deviations from the prescribed instructions can lead to undesirable outcomes. But, not all innovations come with clear and complete instructions. Many high-tech products, especially those with complex architectures and features, for instance very rarely do, and deriving any utility from them requires a great deal of resourceful problem solving.

Manuals for Windows based personal computers and software, for instance, are famously bewildering. This is not simply because of the incompetence of the authors of the manuals. In considerable measure, the sometimes bewildering instructions reflect the complexity of the internal architectures of the systems, the many options and features they contain and the difficulty of anticipating how the components will interact. But whatever its cause, my experience has been that the alluring features of new products rarely work ‘out of the box’ simply by following the instruction manual. I have spent countless hours to get new gizmos to work or to stop inexplicable crashes. And the toil is far from mechanical: I have to guess what might be wrong, conduct experiments, and troll through postings of user groups on the internet trying to find solutions to similar problems. Indeed writing and testing the code that I developed for a real-time trading system some years ago, required less resourceful problem solving than what I have often needed to get a new software package to work.

The effective use of complex enterprise software requires solving both technical and organizational problems. As Koch writes in *The ABCs of ERP*,

> The inherent difficulties of implementing something as complex as ERP is like, well, teaching an elephant to do the hootchy-kootchy. The packages are built from database tables, thousands of them, that IS programmers and end users must set to match their

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business processes; each table has a decision "switch" that leads the software down one decision path or another... [F]iguring out precisely how to set all the switches in the tables requires a deep understanding of the... processes being used to operate the business.

Inevitably business processes themselves have to be "re-engineered". As mentioned, for a user to take advantage of the re-usability of off-the-shelf software packages, they must align their processes with the "best practices" incorporated into the software. And to have a system that is truly enterprise wide, organizations have to figure out processes that work best across their different units. Also inevitably, individuals and organizational sub-units tend to resist changing the way they do things; and even if they didn't, business processes and their associated information systems cannot be changed overnight. Therefore in addition to figuring out what their businesses processes should ultimately look like (and how the "switches" in the software need to be set to match the processes) organizations also need resolve how they will overcome the resistance to change and the transition from 'legacy' processes and systems.

Consultants who have implemented ERP systems in the past can help ameliorate these problems. However, the issues facing different organizations are never identical, so the consultants and their clients have to solve many novel problems. Moreover, ERP packages and the other applications - for instance supply chain, customer relationship management (CRM) and e-commerce software - that ERP is supposed to work with also change, which adds to the difficulty of deriving a 'tried-and-tested' formula for implementation. Researchers and industry experts who have expended considerable effort to investigate what works and what doesn't work have been unable to get beyond long and seemingly wooly lists. For instance Somers and Nelson (2001) have formulated a list of twenty four "critical success factors" that starts with "top management support" and includes items such as "project team competence", "inter-departmental co-operation" and having "clear goals and objectives". For obvious reasons, such lists are just starting points and do little to obviate the need for situation-specific problem solving.

The mixed record of ERP systems also points to the difficult problems that users have to solve to realize the potential benefits. According to Holland and Light (1999), successful implementations at Pioneer New Media Technologies and Monsanto have been well publicized, but "less successful projects have led to bankruptcy proceedings and litigation." Similarly, Plant and Wilcocks (2006) note the success of ERP at companies like Cisco as well as "spectacular" failures at Hershey Foods and FoxMeyer and disappointments at Volkswagen, Whirlpool and W.L. Gore.

## 6. Trading Assumptions

Baumol (2002) suggests that a free market system of innovation provides a positive but small share of the gains to the innovator whereas users get the rest. The proposition makes intuitive sense but is difficult to prove. The profits of the producers can provide at least a crude handle on what they get, but we cannot directly observe the "surplus" secured by the users. And for the reasons already discussed, estimates of the value they derive from their consumption are highly problematic. Researchers have tried several ways of getting around the problem, and although the estimates vary with the method used and the industry studied, they all support the Baumol conjecture, that consumers rather than the producers secure the lion's share.

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For instance, Nordhaus (2005) analyzed data for the non-farm business economy and for major industries in the U.S. He finds that producers captured a "miniscule" fraction of the returns (of the order of 3 percent) from technological advances over the 1948-200 period, "indicating that "most of the benefits of technological change are passed on to consumers." Other studies reporting or implying large consumer surpluses include Mansfield (1977), Bresnahan (1986), Trajtenberg (1989), Hausman (1997) and Baumol (2002)

The critical question for the purposes of this article is whether and how it matters if the producers of upstream innovation are located abroad rather than at home? Do consumers benefit from innovations that originate abroad, or could they as in the North-South models, invoked by Freeman, actually suffer harm? "Economists worry about another place owning the very next big thing" -- the next groundbreaking technology", Stanford's Dan Siciliano told Kronholz (2006). "If the heart and mind of the next great thing emerges somewhere else because the talent is there, then we will be hurt." Are such concerns in fact well-founded?

An important determinant of whether or not innovations abroad help or hurt consumers at home depends on whether the innovations themselves are internationally 'tradable'. If innovators are able and willing to sell their innovations to users everywhere at the same, low price compared to the value, it would not matter a great deal where the innovation originated. In fact, if international financiers provide the capital and share in the returns, the location where the innovation originates would be particularly inconsequential.

Suppose however that innovators export the products that embody their innovations but not the innovations themselves. Now the country of origin secures both the profits from the innovation as well as the wage income associated with the production of the goods and services. Conversely the receiving country has to generate exports not just to pay for the value of value of the innovation but also for the costs of its production.

Such in fact are the assumptions embedded in the North-South models that Freeman relies on to predict "disastrous" consequences for U.S. workers from the loss of the U.S. lead in cutting edge research and technical development. In these models, upstream innovations do not cross national borders. Intermediate goods and services also don't exist or cannot be traded. Only goods and services for final consumption cross national borders. Moreover imports of innovative products lead to the creative destruction of domestic businesses and reduce the purchasing power of local consumers.

But how realistic are these assumptions? I have already argued that innovations don't always destroy. Next I will suggest that actual patterns of international trade are quite the opposite of the assumption in the North-South models that final goods are freely tradable but nothing else is. In fact, upstream innovations (and their associated goods and services) often move *more easily* across national borders, especially of advanced countries, than mid-stream or downstream innovations, goods and services. Moreover, a large proportion of downstream activity in an advanced economy is not traded at all – it is both produced and consumed in the same place.

* And, as long as there is no trade in intermediates, from the point of view of national incomes and expenditures, it is not unreasonable for the models to stipulate that a single player rather than a swarm develops and produces innovative products.

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In pre-industrial times, monarchs sometimes took extreme measures to prevent the export of the distinctive know-how of domestic craftsmen, but even then there was a fair degree of cross-border learning. For instance, to realize his dream of making Russia a naval power, Peter the Great personally studied ship-building in Deptford (in Britain) and in Amsterdam. While in Amsterdam, Peter the Great worked for four months in the largest private shipyard in the world, belonging to the Dutch East India Company. He also hired many skilled shipwrights and seamen who he took back to Russia.

In modern times, countries do impose restrictions on the export of some sensitive technologies but otherwise technology moves across borders without much let or hindrance. Advanced countries which lead in some sectors and technologies import technologies in others. The U.S. which has, according to Prestowitz, Freeman and others, long been the "overall" leader in science and new technology has also benefited from technologies developed overseas. As Carter and Williams (1964) wrote: "All advanced countries draw on the research and development results of other countries, freely or by payment of licence fees or through foreign subsidiaries." In 1960 France "paid abroad" 273 million francs and received 63 million. In 1963 Germany paid 540 million marks and received 200 million. Even the U.S, which enjoyed undisputed technological leadership, and received more than it paid abroad both imported and exported a "great deal of technical knowledge."

Eaton and Kortum (1995) examined the growth in productivity in West Germany, France, the U.K. and the United States between 1950 and 1990. According to their analysis, the growth of the first four countries which started far behind the U.S. at the start of the period, was "primarily the result of research performed abroad." Moreover, notwithstanding its overall lead, "even the United States obtain[ed] over 40 percent of its growth from foreign innovations." These findings, according to Eaton and Kortum are "consistent with historical accounts" of the importance of foreign technology to the U.S. such as Mueller's (1962) description of "the foreign inventions underlying DuPont's innovations."

Certainly, not all innovations travel easily across borders. According to David (2003) innovations are "most efficient as elements of a production system when they have been designed for a specific environment". As mentioned, my on-going research suggests that VC-backed businesses do indeed expend considerable effort in an iterative dialogue with customers in order to determine an optimal bundle of functions, interfaces and so on. Variations in local conditions naturally affect optimal bundles, so products that are well suited to one country maybe inappropriate for another. But such problems are usually less severe with scientific knowledge and upstream innovations, where Freeman and others are most concerned about leadership, than with mid-stream or downstream innovations. Scientific knowledge and upstream innovations tend to be relatively simple and universal. As proximity to end-users increases however, so does the complexity and localization of innovations; moreover, the localization (and often the complexity) grows as innovations evolve over time.

To illustrate: Sir Timothy Berner-Lee's path breaking invention of the core technology of the World Wide Web had no problems from moving out of the CERN lab in Switzerland to anyone anywhere with an internet connection. Browsers that were built around the core technology acquired some localization, most obviously in the language used in the

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interfaces: a browser with English language menu was of limited use to someone who only spoke Swahili. Many subsequent web-based applications then became extensively tailored to local conditions: e-commerce applications for instance reflect local shopping habits, and the business practices of local banks, credit card companies, merchants and privacy regulators.*

The e-commerce example incorporates another feature of advanced economies because of which innovations — be they up, mid, or downstream — abroad aren't much of a threat to the incomes and purchasing power of consumers at home: As is well known, services account for much of the consumption and output in high wage countries. Moreover within the services sector, according to a McKinsey & Co. (2005) projection for 2008, no more than 11 per cent of the 1.46 billion service jobs world wide could even theoretically be performed in an overseas location. The McKinsey estimates also projected that actual off-shore employment in 2008 would amount to just 3 per cent of the theoretical maximum or less than one quarter of one per cent of total service jobs world wide

Of course technological change could allow jobs that have to be performed locally now to be performed remotely in the future or cause such jobs to vanish altogether. Famously, the jobs of most bank tellers have been replaced by a combination of mechanized ATMs and human operators in remote call centers. But history suggests that that 'new want machine' keeps replenishing the demand for service jobs that have to be performed locally.† Unless these historical trends change dramatically, locally performed services will continue to account for a very large share of economic activity.

Since, like Willie Sutton, innovators and entrepreneurs tend to go where the money is, it is not surprising that much of their attention in advanced economies has been directed to improving the productivity of the service sector. Crucially, because most such services are domestically produced and consumed, innovations that improve the productivity in one country do not have much of an impact on other countries. An innovative e-commerce application that improves the efficiency of retailing in the U.S. doesn't reduce the well-being of the Japanese, and the development of a better hospital management software system in Sweden doesn't hurt the U.S. Similarly if the e-commerce application is eventually adapted for Japanese use and hospital software for use in the U.S. the productivity improvements in Japan and the U.S. the countries where these innovations were first introduced aren't hurt either.

Unlike most services, physical goods can and increasingly are being produced far away from where they are consumed. But there does not seem to be much of connection any longer between the locations where innovations occur and the sites where goods are physically produced. Rather, multi-national companies design global supply chains, where factors such as wages, skills and distance from the market determine the placement

* Not all consumer goods and services show great variance across markets and multi-national companies that sell consumer goods do try to standardize their offerings across geographies to minimize costs: Apple for instance sells the same iPod in Europe as it does in the U.S. That said, there are many examples where the upstream components are more localized than the downstream offerings.
† Notwithstanding automation and off-shoring the number of support and administrative staff at Columbia has increased not decreased. The job of cutting paychecks may have been outsourced and there are no punch card operators in the computer center. But twenty years ago there was no one on campus to install and service LCD projectors, personal computer, local area networks or email systems.

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of the individual links. For instance, the Singapore-based Creative Technology Ltd.
invented a hard drive MP3 music player which it started selling in January 2000 as the
Nomad Juke-box. About two years later, in October 2001, Apple introduced the
competing iPod (which Creative alleged infringed on its patent) and the iPod soon
displaced the Nomad as the market leader. But most of the production of MP3 players
takes place in mainland China, not in the U.S. or Singapore.

Similarly, in recent decades the process and product innovations of Japanese car
companies have allowed them to substantially increase their share of the U.S. market at
the expense of the market shares of U.S. companies. But note: although the innovations
have largely originated in Japan, the car companies have increasingly moved the
production of cars for the U.S. market to plants located in the United States. In other
words not only have consumers in the U.S. benefited from innovations originating in
Japan that lowered prices and improved the quality of cars, the wage income derived
from the manufacture of such cars has increasingly shifted to the U.S. Thus, even in
many manufacturing sectors, the ‘make where you innovate’ assumption of the North
South models does not seem to be the norm.

7. Explaining the U.S. lead.

Let us return to the question raised earlier: Why, contrary to 'convergence' theories, and in spite of the alleged erosion of its lead in science and cutting edge technologies, has the U.S. maintained its lead in per capita incomes vis-à-vis Europe and Japan? The analysis above suggests that the exceptional 'entrepreneurial' capacity of firms and individuals in the U.S. to take advantage of upstream innovations regardless of where they might originate, has helped maintain the U.S. lead. (From this perspective, the historical 'primacy' of the U.S. in many scientific and technological fields may be more a by-product rather than a cause of U.S. prosperity. Just as the rich make larger contributions to the Arts than the not-so-well off, prosperous countries are more likely to contribute to research on string theory or the decoding of the genome than poor countries.* And as prosperity becomes more widespread, more countries contribute to the world's stock of scientific knowledge. This helps rather than hurts the countries that once took the main responsibility.)

Venturesome consumption of innovations in IT – a sector which according to Nick
Bloom, Raffaella Sadun and John Van Reenen (2005) has accounted for much of the
acceleration of U.S. productivity since 1995 – appears to have played a particularly
important role in maintaining the U.S. lead. As mentioned, Prestowitz (2006a) sees the
U.S. trade deficit in IT and other advanced technology products as a symptom of a
faltering economy. In my interpretation, this deficit is an indicator of economic strength
and dynamism, not weakness. As we will see next, the U.S. has a voracious appetite for

* Accroding to Teresi (2004 p.38) the physicist Robert Wilson appeared before Congress to secure $250 million for building Fermilab, the largest particle accelerator in the world. A friendly Congressman tossed a "softball" question, that gave Wilson the opportunity to justify the new atom smasher using national defense." Wilson insisted that it had "nothing at all" to do with national security. Rather Wilson said "It has only to do with the respect with which we regard one another, the dignity of men, our love of culture. It has to do with, are we good painters, good sculptors, great poets? I mean all the things we really venerate and honor in our country and are patriotic about. It has nothing to do directly with defending our country except to make it worth defending."

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IT goods and services, many of which are made in countries in China, Taiwan and other countries where wages and manufacturing costs are relatively low. A high propensity to use IT generates deficits but it also, as the evidence we will review suggests, enhances productivity in IT-using industries which account for a much larger share of economic activity than the IT industry itself.

## *Consumption patterns*

Tables 2a and 2b contain data on the sales of Windows, Linux and other operating systems for personal computers and servers by selected regions and selected countries for 2001.* To construct this table, sales of operating systems (as available, in terms of units and revenues) were divided by GDP for the region or country. The sales to GDP ratios were then 'scaled' by the sales to GDP ratio for the U.S. The tables show that Windows operating systems sales to GDP ratios for Western Europe were about 25% lower than in the U.S. and in Japan more than 10% lower. Within Western Europe, only two countries, namely Sweden and Denmark, had higher sales to GDP ratios than the U.S. The GDPs of these two countries are however small so their total sales amounted to about one twentieth of U.S. sales. Among the relatively large West European countries, GDP to sales ratios were about a third lower than the U.S ratios in Germany, France and Italy and about 10 percent lower in the U.K.

The U.S. isn't the leading user of IT in every category. As has been pointed out by Prestowitz (2006) and many others, The U.S. has become a laggard in broadband deployment. As of 2005 the U.S. was behind 15 other countries in terms of the number of broadband subscribers per 100 inhabitants. Similarly, Prestowitz also cites data showing that the U.S. is 42nd in the world in cell phone usage: In 2003 cell phone subscriptions per 100 inhabitants in the U.S. were almost half the subscriptions in Italy. The U.S. has also lagged behind Korea, Japan and many countries in Europe in the deployment of 3G high-speed wireless data systems. But these exceptions apart, the US leads in terms of overall IT consumption, just as it does in the purchases of operating systems.

Table 3 compares total IT expenditures (as estimated by the Gartner Group in its *Market Data books*) across selected regions and countries for 2001-4. As in the previous table, total expenditures are divided by GDP and this ratio is compared to the US expenditure to GDP. Here too we find that the IT expenditure to GDP ratio in Western Europe is between 15-20% lower than in the U.S. and in Japan it ranges from 10 to 30% lower than in the U.S. over these four years.

## *Productivity gains*

Until not so long ago, there was debate about whether the IT investment had done the U.S. economy much good. In 1987, Robert Solow wrote: "We see the computer age everywhere, except in the productivity statistics." The following year, Steven Roach (1988) of Morgan Stanley dubbed this the "productivity paradox". In 1991, the *Economist* pointed out that the returns from IT investments were so low that firms "would have done better to have invested their money in almost any other part of their business." On the other side, Paul David (1990) argued that it was too early to judge the value of computers - it took decades for the productivity benefits of the electric dynamo

* The data used to construct the table was generously provided by Pankaj Ghemawat and Ramon Casadesus-Masanell who had collected and used the data (in a very different way) for their 2006 article.

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(whose technical development had been largely completed by 1880) to be realized. Griliches (1994) and others also suggested that the productivity paradox reflected a measurement problem: users realized many benefits from IT in forms such as greater variety, convenience or quality which are missed in standard GDP accounting.

By 1996 the annual IT spending of U.S. firms had crossed half a trillion dollars and organizations like Nations Bank had annual IT budgets of $2 billion a year (Lucas 1999). Yet Gordon (1999) suggested this was all for naught, so far as the economy was concerned. According to Gordon, the acceleration of productivity in the U.S. that occurred after the mid-1990s was almost entirely due to more efficient production of IT, particularly computers, rather than to the use of IT. Jorgenson and Stiroh (2000) came to similar conclusions: the acceleration of productivity growth after 1995 could be "traced in substantial part" to improvements in the production of IT. On the user side there had been some "capital deepening"—as computers got cheaper, firms bought more of them. The evidence was clear they wrote that "computer-using industries like finance, insurance, and real estate (FIRE) and services" had "continued to lag in productivity growth" in spite of their "massive high-tech investment."

As someone who studies entrepreneurs and businesses from the ground up, I find the Jorgenson and Stiroh claim puzzling. First, by the year 2000, computer using industries had undergone vast changes over nearly two decades. The rise of new big-box retailers, most notably Wal-Mart, had displaced many traditional players. Similarly small regional banks had been merged into mega-sized national institutions like Citicorp and the Bank of America or had disappeared. With the new players came new ways of doing business — Wal-Mart established global supply chains and regional distribution centers for instance. The old players and ways of doing business didn't fall like trees stricken with Dutch elm disease. The old order was pushed out by the new after a competitive struggle in the marketplace. How could this have happened unless in some way shape or form the new was more 'productive' that the old?

Second, could business facing relentless pressure from rivals and the capital market simply have thrown away the greater part of half a trillion dollars in IT spending a year? I once suggested (Bhidé 1986) that banks and other financial institutions overestimate the sustainability of the competitive advantages they can derive from investing in technologies because they overlook the possibility of imitation: if one bank builds ATMs that customers value, others soon will as well. But, this simply means that customers, not the banks derive most of the benefit. For the technological 'arms race' to have no productivity benefit, competitors must all invest in innovations that even customers don't value — much of the half a trillion dollars invested in IT would have to have been totally wasted.

Third, could IT-using industries really improve their output per worker just from 'capital deepening', without finding new ways to use that capital? It is one thing to say that as the costs of vacuum cleaners and dishwashers decline, less labor will be required to clean floors and dishes because more capital equipment will be used. But I don't think that my writing will go faster if I had two computers instead of one (or got a computer with twice the processor speed as my current model). The idea of simply plugging more IT gear into the existing production function of a large organization becomes particularly far-fetched in light of the extensive reengineering that the implementation of new systems actually

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entails. Finally it is surprising to find that the models assume perfectly competitive product and factor markets. If this was in fact the case, why would anyone try to develop productivity enhancing techniques in the first place? Does not the assumption preclude the phenomena?†

In any event, the debate seems to be largely over now. As Dedrick, Gurbaxani and Kraemer (2003) conclude after reviewing the literature, "the productivity paradox as first formulated has been effectively refuted. At both the firm and the country level, greater investment in IT is associated with greater productivity growth." Moreover, at the firm level, "IT is not simply a tool for automating existing processes, but is more importantly an enabler of organizational changes that can lead to additional productivity gains."

The literature also suggests that the U.S. is at the forefront of realizing the productivity gains. Bloom, Sadun and Van Reenen (2005) write that whereas in the U.S., significant gains in productivity have been realized in sectors that intensively use and produce IT, the EU has seen similar productivity acceleration just in the IT-producing sector. In sectors "that use IT intensively", such as retail, wholesale and financial intermediation, European countries have not enjoyed the "spectacular levels of productivity growth" as in the U.S. "Britain has done better than France or Germany, but not as well as the U.S.†

Similarly Robert Gordon, who in 1999 had written that there had been virtually "no productivity growth acceleration in the 99 percent of the [U.S] economy located outside the sector which manufactures computer hardware" was subsequently persuaded that: "After fifty years of catching up to the U. S. level of productivity, since 1995 Europe has been falling behind... studies of industrial sectors suggest that the main difference between Europe and the U. S. is in ICT-using industries like wholesale and retail trade." (Gordon 2004)

## Venturesomeness of IT Users

The significantly higher propensity of US businesses to buy IT does not seem to reflect a generally higher propensity to invest in fixed capital, because of some general economy-wide factors like low interest or discount rates or a tax breaks for long term investment. The tables (2a-b and 3) on operating system sales and total IT expenditures also contain columns on the ratios of total Gross Fixed Investment (in all categories) to GDP. These columns show that the U.S. *lags* in overall fixed investment by about the same degree as it leads in IT spending. The ratio of gross-fixed investment to GDP is about 50% higher in the Japan than in the U.S. and in Western Europe about 25% higher. Table 2b also shows that there is not a single country in Europe where the ratio of Gross Fixed Investment to GDP is lower than in the U.S.⁸

My hypothesis is that the comparatively high propensity of the U.S. to buy IT (which is available throughout the world at roughly similar prices) in *spite* of a low overall rate of investment reflects an exceptional level of 'venturesome consumption': First, buyers of IT in the U.S. are willing to take their chances on novel technologies where no one has much evidence on the risks and the returns. I have no systematic knowledge about

* Brynjolfsson (1993) made a strong case that the IT "productivity paradox" reflected deficiencies in the measurements and methodological tool kits. This apparently did not dissuade researchers from continuing to use these measurements and methods.
† See also O'Mahony and Van Ark, 2003

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buying habits outside the U.S. but at least some of the vendors of enterprise software we have interviewed said that European IT staff tend to be "risk averse" and prefer more stable, older generation products. Second, U.S. purchasers of IT may be more bold and resourceful in making the organizational changes needed to derive the full benefit of ERP and other such systems.

The venturesomeness of IT users in the U.S. – and the large size of the market – helps attract suppliers. According to the entrepreneurs we have been interviewing recently, the U.S. is the market of first resort for most IT vendors. Indeed the attractiveness of the U.S. market had caused some of our interviewees who had started their businesses in Europe to relocate to the U.S. to be close to their target customers. And to the extent that suppliers refine their products through a dialogue with U.S. customers, their features are optimized to the U.S. market. This in turn makes the product more attractive to U.S. customers rather than to customers outside the U.S.; it also creates an incentive for suppliers to continue to focus their sales efforts on U.S customers (because selling outside the U.S. might require additional costs to adapt the product to local conditions.)

Bloom, Sadun and Van Reenen's (2005) research suggests that the unusual willingness to invest in IT and the capacity to derive value from such investments is sufficiently embedded into the structures and routines of U.S. based companies that they carry this capacity to their operations outside the U.S. They compared the establishments based in the U.K that were owned by U.S. multinationals, non-U.S. multinationals and domestic (i.e. U.K.-based) companies. They found that establishments owned by U.S. multinationals invested about 41% more per employees in IT than the average for the industry; non-U.S. multinationals about 20% more, while domestic companies invested about 15% less than the industry average. U.S. multinationals also apparently got more for their IT buck; they enjoyed "significantly higher productivity of IT capital" – this effect accounted for "almost all the difference between the overall productivity of resources used by U.S. owned and all other establishments. And, they found that the 'IT edge' of U.S. multinationals was "confined to the same 'IT using intensive' industries that largely accounted for US productivity growth acceleration since the mid 1990s.

I should emphasize that success of IT-using industries in the U.S. has not in any material way reduced incomes in the rest of the world, because their outputs are usually not 'tradable' exports. When U.S. multinationals use their productivity advantages to establish operations abroad, they may wipe out local firms but their activities (like those of Japanese owned automobile plants in the U.S.) generate wage incomes and consumer surpluses that remain almost entirely with their host countries. And, investors abroad have the same opportunity to share in the profits of U.S. multinationals (buy buying their shares) as do U.S. nationals.

I should further note that although developed countries in Europe and elsewhere may be somewhat behind the U.S. in using IT, they are well ahead of emerging and underdeveloped countries. My interviews suggest that in spite of the economic boom in China and other Asian countries, after the U.S., the European market is the next port of call for most IT innovators. And even if products are initially optimized for the U.S., potential users in Europe are not so very different that the products cannot be 'Europeanized' or that Europeans cannot learn to live with products developed for the U.S. Arguably, the superior capacity of Europe to use advanced products vis-à-vis most

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other countries has mitigated the effects of what many consider to be dysfunctional public policies. To slightly extend Adam Smith's adage, there is much ruin in a nation, once its capacity to use innovative goods and services is sufficiently advanced.

## 8. Elusive underpinnings.

In the Parente and Prescott (1994) model, all countries draw their technologies from a common pool that keeps getting bigger and better; however the investments that firms have to make to take advantage of the ever-improving pool depends on the "barriers to technology adoption" in their countries. Parente and Prescott mention "regulatory and legal constraints, bribes that must be paid, violence or threats of violence, outright sabotage, and worker strikes" as examples of the forms that the barriers can take, but that is not their focus. Rather, according to their theory, whatever form the barriers may take, the differences in their magnitude do not have to be "implausibly large" to account for the "huge observed income disparity" across the rich and poor countries.

But what form do these barriers in fact take and why do they vary across countries? David (1986) reviews the extensive theoretical and empirical research on the economics of technology diffusion. The review shows that a great deal of work has been done on the incentives that firms face and the costs they incur in adopting new technologies. These findings help explain differences in the rates of the adoption across industries and firms and help us analyze whether, from a social welfare point of view, the rates are too slow or fast. The research does not however examine the sources of the differences in rates of new technology adoption across countries (whose economies comprise many industries and firms). Similarly Cohen and Levinthal (and other researchers such as Cockburn and Henderson 1998) who have worked on 'absorptive capacity' peek 'under the hood' of firms to examine how their strategies affect their adoption of new technologies, but not why such strategies might vary across countries. Moreover, this line of research focuses on 'upstream' high-tech businesses, and it is difficult to extrapolate the findings to service sectors that now dominate advanced economies.

Nelson and Phelps (1966) offer the general (i.e. economy-wide) hypothesis that "education speeds the process of technological diffusion." The "better educated farmer" will adopt a profitable process more quickly since "he is better able to discriminate between promising and unpromising ideas." In large industrial corporations, educated scientists keep abreast of technological improvements and educated top managers make the final decision. Therefore as a general principle, the "time lag between the creation of a new technique is a decreasing function of ...average educational attainment."

Although education surely matters, it cannot be a sufficient condition for the rapid adoption of new technologies. The erstwhile Soviet Union had a well-educated population and few qualms about infringing on foreign patents; nonetheless it remained far behind the Western technological frontier. Nor does the 'supply side' prescription of low taxes, free markets and property rights seem to ensure a high level of venturesome consumption. As a native of India who grew up under avowedly socialistic government, I am acutely aware of the debilitating consequences of confiscatory tax rates, pervasive regulation and expropriation of private property.

But, the economic record before Independence under a colonial regime strongly oriented towards maintaining a low tax regime, free domestic markets, free international trade,

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and the rule of law, was even worse. Not only did India miss the Industrial Revolution, in its manufacturing industry, as Bhidé and Phelps (2005) have pointed out, under colonial rule it even failed to 'learn' how to consume modern goods. Although, according to the prevailing imperial ideology (and Marxist analyses) colonies were supposed to provide captive export markets for their European *metropoles* India's imports were persistently lower than its exports.

The 'institutions', or what Ohzawa and Rosovsky (1973) called 'social capabilities', that sustain the venturesome consumption and other sources of prosperity of advanced economies cannot be reduced to a few well-defined elements. The formula is both complex (see Nelson 2006) and ever changing. For instance, the common beliefs that now undergird the demand for new products and services have distinctively modern features.

The widespread belief in the inevitability and desirability of technological progress is an important case in point. In earlier times, a relatively small number of visionary inventors and scientists held such views. Now many popular magazines, TV shows and management books are predicated on the assumption of scientific and technological progress. Their growing acceptance has turned such beliefs into self-fulfilling prophecies. Consider for instance Gordon Moore's famous observation that the number of transistors that built on a chip doubles every eighteen months. Semi-conductor companies, who believe in this so-called "law", invest the resources needed to make it come true. Downstream customers, (such as PC manufacturers) and providers of complementary goods to their customers (such as applications software companies) design products in anticipation of the eighteen months cycle. So when the new chips arrive they find a ready market, which in turn validates beliefs in Moore's Law and encourages even more investment in building and using new chips.

In principle, expectations of change can also slow it down – as David (1986) puts it “if it is expected that every one will quickly adopt the [new] technology, the inducements to bear the costs are of adopting it early are reduced”. Why buy the $5000 flat panel TV set now, when a year from now the price will surely drop and the reliability of the models will increase? Apparently, a sizeable number of users derive utility not just from the functions that the new products provide but from the fact of being early adopters. As Keynes (1930. p. 326) pointed out, people have both ‘absolute’ needs (e.g. for health and survival) as well as ‘relative’ needs that we feel “only if their satisfaction lifts us above, makes us feel superior to, our fellows”. Early purchasers of goods like flat panel TVs apparently enter into a tacit bargain with other consumers: they incur the higher risks and costs which then drives down prices and improves the quality for the consumers who ‘wait’; in return, those who wait, give the early purchasers the gratification of being first.

The gratification that many modern consumers enjoy may be contrasted with the long-standing propensity to consume expensive goods for the sake of displaying status or wealth – the “conspicuous consumption” of the Gilded Age that Thorstein Veblen wrote about in *The Theory of the Leisure Class*. Only the wealthy can indulge in conspicuous consumption; moreover as Veblen put it, to satisfy its purpose – the demonstration of wealth – the consumption “must be wasteful.” In contrast, many early purchasers of the latest gadgetry aren’t flush with cash (or even pretending to be); they seek to display, to

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themselves and to others, their technological sophistication, not their wealth. (The classic form of conspicuous consumption has certainly not disappeared however.)

The propensity of consumers to open their hearts and wallets to new offerings also involves the dilution of prior beliefs in the moral and economic value of thrift. Through the end of the 19th century, according to Max Weber's thesis, religious convictions about thrift sustained the 'spirit of capitalism'. Weber argued that merchants and industrialists accumulated capital believed they had a moral duty to strive for wealth as well as to lead austere lives. In fact, because venturesome production requires venturesome consumption, excessive thrift can injure rather than helps modern capitalism. As it happens, modern consumers have been more inclined to keep up with the recently acquired baubles of their neighbors (if not stay ahead) than towards excessive thrift.

The utility that individuals now derive from using cutting edge technology can also stimulate business purchases of IT if the IT staff put their love for the latest toys ahead of their employers' interests. Astute managers who are aware of this tendency can resist this however. But even managers who have no love for technology *per se*, may embrace its large scale use for another reason, namely the pressure they face to grow their organizations. As I have argued (Bhidé 2000 Ch. 9) in a dynamic modern economy, competitors, customers, capital markets, and labor markets make it difficult to avoid growth; as David Packard and William Hewlett (the founders of H-P) concluded, the growth of a company is "a requirement for survival." Growth in turn facilitates and encourages firms to use IT and other innovative technologies in several ways.

First, the scale effects documented by Davies (1979) in the adoption of innovations in the manufacturing sector continue to be found in the adoption of many IT products by service companies. Unlike Wal-Mart, a small retailer cannot afford to purchase a license for a sophisticated supply chain management software package or pay for the in-house IT staff necessary to install and maintain the package. Moreover, since the vendors' cost of marketing their packages also tends to be fixed, they tend to favor large customers who buy large (or many packages).

Second, growing companies often start new facilities, where it is both easier and more economical to adopt new technologies. As David (1986) writes, while an old plant may be technologically obsolete, it may still cover its variable costs and make it rational for profit maximizing to defer replacing it with a state of the art plant. Moreover it can be operationally disruptive to pull out the old technology. Neither consideration applies with a green-field facility. It is worth noting here that the main differences in the productivity of European and U.S. retailing are in the arena of "big box" retailers (like Wal-Mart) and within this category, the U.S. edge derives mainly from its newly opened retail outlets.

Third, the effort to grow can stimulate the search for innovative technologies that can be used to realize economies of scale and scope. For instance in 1988 Physicians Sales and Services (a company I have written a case series about) was an "itty bitty company in Florida". In 1989, the founder Pat Kelly declared that PSS would become the first national distributor of medical products to physicians' offices in the U.S. With just $20 million in revenues, it had no significant economies of scale that would justify nationwide operation. Like a lot of young companies Kelly recalls, PSS relied on "hard work", "good people", "seat of the pants navigation", and "a lot of luck." The goal of becoming a national company, (which was displayed in big banners in every branch and

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repeated endlessly by Kelly and his top managers) provided the impetus to search for
economies of scale. For instance the company invested in an order entry system based on
hand held computers which increased the speed of deliveries and enabled PSS to reduce
the inventories it had to carry. Such initiatives allowed PSS to create national level scale
economies where none had previously existed.

These kinds of underpinnings – the pervasive belief in change, the value placed on being the first user, and the pressure faced by managers to grow – cannot be easily measured, nor can we identify the nature of their interactions or their ‘ultimate’ sources. But to ignore such factors on the grounds of their elusiveness is to exclude from considerations the essential and distinctively modern ways in which innovation sustains the prosperity of advanced countries.

9. Redressing the up-stream bias.

David (1986) makes several noteworthy points about how public policy affects the use of
new technologies: 1) Overt efforts to promote the diffusion of innovations are modest in
terms both of money and attention devoted to them. They usually comprise efforts to
disseminate information (such as agricultural extension or "technology transfer"
programs in the U.S.) or the payment of subsidies to adopters of new technologies (such
as those offered to purchasers of robots in Japan). 2) The range of policies that actually
affect the adoption of new technologies is quite broad. These include the "tax treatment
of investment, the funding of R&D, the education of scientists and engineers, regulation
and standard setting, as well as the monetary and fiscal measures shaping the
macroeconomic environment." 3) Speeding up the rate of technology innovation isn't
always in the public interest; sometimes, slowing it down could be more beneficial. 4)
Policies to quicken or retard the adoption of new technologies should only be undertaken
after "explicit assessments" of the varied and changing environments of different
industries: an "absolutely indispensable ingredient in the formulation of rational
economic policies" vis-à-vis diffusion is "detailed assessments on an industry-by-
industry basis". 5) The processes of the development and diffusion of new technologies
are closely intertwined; therefore "intelligent" policymaking would take a more
"integrated" approach to designing innovation and diffusion policies.

The policy implications of this paper are in many respects similar to David's
observations, save in two respects, namely in the utility of a case by case approach and
the feasibility of formulating an integrated approach to promoting technology
development and diffusion. On the first issue: I have little doubt that the binding
constraints or pinch points vary significantly across markets and sub-markets. Looking at
the health care sector for instance we can see some diseases whose cures await an
"upstream" scientific breakthrough. In other instances improved management of hospitals
and patient data-bases using tried and tested technologies can lead to vast improvements
in productivity. And in yet other cases, the social value of the increased use of therapies
and techniques that can be called medical in only the broadest sense of the term seems
dubious under a system where the users don't pay.

The record of 'case-by-case' interventions however does not appear to be inspiring. The approach obviously invites efforts, both overt and covert, by lobbies to secure results that suit their private ends. The process of public policy making is also slow - and indeed, to

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secure the legitimacy of openness and the accommodation of many points of view – in most cases public policy ought to be formulated with all due deliberation. But technologies and their associated bottlenecks keep changing so interventions that might have been apropos yesterday may be irrelevant tomorrow. There is no point for instance in promoting “hardwired” broadband connections to the internet if we are on the verge of a cheaper or better wireless alternative.

Finally suppose policy makers could identify the ‘right’ bottlenecks across all industries in a timely manner: they would still be faced with the problem of formulating effective responses. As I have argued in this paper, the development and the use of new technologies has entrepreneurial features that lie outside the domain of mainstream economics; and while we may crudely describe their manifestations their underpinnings are elusive. But economic and policy analysts tend to focus on measurable indicators and relationships. The danger is that such an orientation may not only fail to touch the larger but more elusive barriers to progress, they may actually increase these barriers.

The same concerns about our profound ignorance of the underlying factors make me skeptical about integrated approaches to the development and diffusion of innovation – a fine principle perhaps, but, do we know enough to implement it?

The arguments in this paper do however suggest the removal of the tendency of policy makers to favor upstream innovation and neglect or even impair what happens mid- and downstream. Such a bias is apparent in the promotion of research and the denigration of marketing; thus pharmaceutical companies who receive substantial tax credits or subsidies for their R&D programs get a tongue lashing for their marketing. Spend more on developing new drugs Big-Pharma is told instead of spending so much on peddling “frivolous” drugs. But, the frivolous drugs also start in a lab. Moreover even useful drugs can only be effective if they are properly incorporated in a therapeutic regime; and as McGettigan et. al. (2001) study suggests, whereas doctors may say they get their information from reading medical journals, pharmaceutical company salesmen play a more important role in influencing their prescribing habits.

Without a marketing push, breakthrough treatments may fail to catch on. Consider the history of using antibiotics to treat ulcers which suggests an important role for marketing beyond the passive dissemination of information. Warren and Marshall demonstrated a link between helicobacter pylori to peptic ulcers in the early 1980s. In 1987 Couglan et. al, published an article in Lancet showing that the eradication of H. pylori with antibiotics could effectively cure peptic ulcers. This further milestone was then followed in the first half of the 1990s by the publication of national and international guidelines on the treatment of H. pylori. But although the consensus guidelines were clear, pharmaceutical companies did not have an incentive to promote the therapies. A literature review by O'Connor (2002) showed that although there was "widespread acceptance of H. pylori as a causal agent" among physicians in principle, there was "significant under-treatment" of peptic ulcers with H. pylori therapies. And, physicians who did use the therapies often used "treatment regimens of doubtful efficacy" instead of following the consensus guidelines.*

* This data led O'Connor to suggest the use of "some of the methods used by pharmaceutical manufacturers to educate physicians about their products, which are known to be effective and often overshadow the

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Marketing plays an even more important role in realizing the value of innovations where there are no guidelines offered by authoritative professional bodies and users face significant Knightian uncertainty about the utility of their purchases. Even consumers who are innately venturesome need some persuasion. In fact persuasion is a crucial entrepreneurial function and often involves the use of smoke and mirrors and psychological manipulation. Policy makers and others may find the misrepresentations and manipulations distasteful but they are an essential ingredient of technological progress.

Conversely incentives to promote R&D may help upstream innovators but do little good for the downstream and mid-stream players. Retailers like Wal-Mart may have very large IT budgets and staff who may even develop some in-house systems. But none of this qualifies for R&D incentives. The output of mid-stream innovators (such as the VC-backed firms I have been studying) may in principle qualify for R&D subsidies; in practice however, many such firms not only lack the earnings needed to take advantage of tax credits, often they also cannot easily segregate R&D outlays and activities from those of their other functions such as marketing and sales.

Efforts to stimulate "savings and investment" also tilt against mid and down-stream innovations. There appears to be a consensus among policy makers of many stripes, that except possibly in recessions, saving is always virtuous and consumption undermines long term growth. - a mindset exemplified by Prestowitz's (2006c) alarm that the U.S. "is building its economy into a giant consumption machine". Mechanisms to mobilize savings such as the stock market and retirement plans are thus regarded with favor while mechanisms that facilitate consumption, like credit cards with some suspicion. But, as I have argued, Max Weber's thesis that capitalism is synonymous with capital accumulation ignores the role that the venturesome consumption of innovative goods plays in a modern economy. Moreover, the young and the impecunious are more likely to have the recklessness of spirit necessary to perform this role. At least up to a point, their spendthrift ways and the credit cards that sustain them are a boon to economic growth; and because there is no knowing what that point might be, there is no justification for promoting or discouraging their behavior.

Similarly, policies to promote long term investment by, for instance, providing tax credits for capital outlays also seem to be outdated. The modern knowledge economy appears to have erased the old boundaries between long-term investment and (supposedly undesirable) short-term spending. Much of what would traditionally have been categorized as the spending of mid- and downstream players is in fact, risky, long term investment. For instance, as discussed the purchase price of an ERP system is a fraction of the total project cost; but businesses eligible for an investment tax credit for their purchases of computer hardware and software don't receive a tax break for the costs of adapting the system to their needs, training users, reengineering their business processes and so on. It may be that a tax credit for the computers also encourages the other, larger outlays. But to the extent that promoting long term investment is in fact a worthy goal for tax policy, this seems like a round-about and inefficient way to achieve this purpose.

information available in the medical literature." But who could do this? Replicating a good marketing system is easier said than done.

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(The tax credit may, for instance, encourage a business to invest more in the computers and less on user training and reengineering.)

The goals of educational and immigration policies are more attuned to the labor requirements of upstream innovation. For instance, there is a long-standing claim in the U.S. that it should train more engineers and scientists. If this were done, the costs or labor supply constraints faced by organizations undertaking R&D would be reduced. But this invites the question: whose labor supplies would tighten — what have all the people who otherwise might have become scientists and engineers been doing? And has this been less productive than if they had been working as engineers and scientists?

The data suggests that many individuals who could have been engineers or scientists have been working as managers. The progressive increase in the proportion of service sector jobs is well known; many have not noticed however, the increasing share of managerial and professional jobs — in the U.S. from about one in six in 1940 to about one in three today (Bird 2004). Some of the managerial positions may be filled by individuals who have engineering degrees but such training is probably not a job requirement.

The growth in managerial jobs, which in the last couple of decades has taken place in a climate of cost-cutting, restructuring and re-engineering, probably does not reflect a spontaneous increase in bureaucratization of U.S. companies. More likely it follows from the growth of activities, particularly in the expanding service sector, that are difficult to coordinate and where economies of scale and scope are difficult to come by. Moreover, these managers have been at the forefront of the challenging effort to improve the productivity of services sector. As we have seen, the use of technologies such as ERP pose organizational as well as technical challenges; arguably their implementation requires a much higher ratio of managers to technical personnel than did the productivity increasing technologies in the manufacturing sector. In other words, the labor market may not have gotten it monumentally wrong and interventions that increase the supply of trained personnel for upstream innovators may impair productivity growth by reducing the availability of the personnel in downstream firms.

We find a similar bias in the area of immigration policy which takes the form of preferring highly trained engineers and scientists (i.e. those with PhDs and Masters degrees) to individuals with just a bachelors' degree. Highly trained immigrants, it is believed, can make out of the ordinary contributions to innovation because they are in such short supply whereas engineering and scientific jobs that don't require advanced degrees can easily be filled in the local labor market. In fact as I have just pointed out, the highest valued use of talented locally born individuals may not lie in scientific and engineering jobs at all, and as a result immigrants who don't have advanced degrees have probably made as valuable a contribution as those have advanced degrees. As mentioned in my ongoing study of VC-backed businesses for instance we have found that a relatively small proportion of employees in these ostensibly high-tech firms have masters and PhDs. Correspondingly, the number of immigrants who have PhDs or Masters degrees is also much smaller than the number of immigrants (who usually work in a technical function) whose highest degree is a bachelors. I do not have data on the composition of immigrants on the technical staffs of organizations such as retailers and banks; I would suspect however that they have an even lower proportion of immigrants with advanced degrees.

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I could go on to discuss policies in the areas of anti-trust enforcement, land use and labor mobility that encourage or discourage the adoption of new technologies by influencing the incentives and ability of downstream players to grow their organizations. But rather than make this survey even more cursory, let me conclude by returning to the main topic of this conference: whether or not Continental Europe is sinking, and if so, why?

As must be apparent, I have not much of a notion. But my perspective, from having had the good fortune to spend my adult life in a place that has enjoyed unparalleled prosperity, is that a vibrant economy is a many-splendored thing. Although depending on from where one looks one or the other facet may sparkle, the magic of the system lies in the whole, in its many components and their subtle relationships. Moreover, like the innovations it generates, the system evolves constantly. Although basic human nature may remain the same, our expectations, desires, social compacts, relative positions, and technologies all change. Not so long ago, we might have worried about the rust in manufacturing sector; now concerns about the productivity of services seem more pressing. This is not our grandfather's economy or Adam Smith's, or David Ricardo's or Max Weber's economy. And while parsimonious models may provide a starting point, useful ideas – ones which a pragmatist like William James would say have “cash value” – about why the economy is surging or stalling must incorporate the many and distinctively modern features of our lives.

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Notes:

¹ Over 30 years after the introduction of minicomputers and more than 20 years after the introduction of microcomputers, the mainframe remains an important category. Total worldwide revenues of large-scale computer processors (or mainframes) amounted to $16 billion in 1997 compared to $16.2 billion in 1982. But because total demand grew from $38 billion to $183 billion, mainframes' share of the total computer market dropped considerably, from 42% to about 9%. (Bhide 2000)

² Innovations that created markets for new goods and services gave lie to predictions that mechanization and mass production would create mass unemployment. Productivity improvements on the farm reduced agricultural employment in the U.S. from 11.7 million in 1900 to 5.9 million in 1960. Changes in production technologies also put many highly skilled artisans out of work. But, total employment more than doubled – from 29 million in 1900 to 68 million in 1960. The labor released by the farm and workshop was quickly absorbed by factories established to serve new markets (and the increased demand for old goods). The assembly line worker also earned more than the farmer or skilled artisan. For instance by 1900, the average annual manufacturing wage was more than twice the agricultural wage and this gap continued to widen through the first seven decades of the 20th century.

Products that satisfied new wants also created jobs in new service industries. Refrigerators and air-conditioners had to be transported, advertised, sold by a new kind of retailer, installed and periodically serviced. The transportation, advertising, retailing and other such 'service' industries in fact created more jobs than the manufacturing sector. As early as 1920 – long before the term the 'service economy' had been coined – employment in trade, transportation and other private service providing sectors was 15% greater than in the manufacturing. By the end of the 1960s, employment was nearly 70% greater.

Although wages in the manufacturing sector stagnated after the 1970s, and manufacturing jobs topped out at about 20 million in 1980, overall employment and incomes in the U.S. continued to rise. T

Holger Klitzing

Schönauer Str. 11
+49-6203-954686

D-69198 Schriesheim
hklitzing@web.de

Germany

SEP 01 2006

Dr. Henry A. Kissinger
Twenty-Sixth Floor
350 Park Ave.
New York, NY 10022

July 27, 2006

Dear Dr. Kissinger:

Recently I completed my Ph.D. in history at the University of Heidelberg with a study entitled "The Nemesis of Stability: Henry A. Kissinger's Ambivalent Relationship with Germany". Included in this package you find a copy of my dissertation, which might be of interest to you. Since I am currently preparing the manuscript for publication, I would appreciate any comments or suggestions you may have.

Sincerely,