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Innovation Doesn't Always Start in the Garage

Noah Smith is a Bloomberg View columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.
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I’m a fan of the idea of disruptive innovation. Popularized by Harvard business professor Clay Christensen, this happens when a company offers new or cheap products for market segments overlooked by big incumbent players. Eventually, after gaining a foothold, the newcomers move up-market and overtake the established companies. This is one way to get creative destruction -- an older and more general concept popularized by economist Joseph Schumpeter, in which industrial churn leads to greater productivity growth. Successful disruption clears away corporate deadwood, and the opportunity for disruption gives hungry young businesses an incentive to innovate.

Economists often trumpet creative destruction, and there’s lots of research on its effects. But recently, there has been a bit more focus on the other source of private-sector innovation -- incremental improvements by large companies. Even as we celebrate disruption, we shouldn’t forget that big companies are critical players in the innovation game.

Recently, some economists have tried to tackle the question of how much innovation comes from existing companies, and how much comes from new ones. Measuring innovation is tough for economists, since you can’t observe it directly. For that reason, you usually have to use a theoretical model that tells you how research input -- such as research and development spending -- gets converted into research output.

Models like this have existed for a while. But I was intrigued by a recent paper by Daniel Garcia-Macia, Chang-Tai Hsieh and Peter Klenow, which directly tackles the question of whether new companies or big established ones are responsible for more innovation.

The authors assume, realistically, that innovation can come in two forms -- you can either create new products, or you can improve the quality of your old products. But they also assume that truly new products arrive randomly. Existing companies can’t just wake up and decide to invent a self-driving car; they have to wait for the technology to be ready. Maybe the tech comes out of university research, maybe it comes from a lucky combination of existing elements, but it happens randomly. The only kind of innovation existing companies can do voluntarily in this model is to work on upgrading their existing product lines.

Models like this are hard to make, and even harder to test against data. If the authors allowed for old companies to deliberately produce new inventions -- as Apple did with the iPhone a decade ago -- it would make the theory even more complex and harder to test.

It turns out, however, that even if established companies are only able to make incremental improvements, Garcia-Macia et al. find that the incumbents are still responsible for the bulk of innovation. New companies with disruptive technologies arrive all the time, forcing the incumbents to race to stay ahead by upgrading their existing offerings. That effort results in a huge amount of innovation.

The result? The authors tentatively conclude that about two-thirds of the innovation in the economy comes from incumbents, instead of from newcomers. The threat and pressure of disruption is crucial. But in the end, real progress is more often the result of a successful response to that threat.

Now, as with any macroeconomic model, we should remember that this is just a thought experiment, not a well-tested theory. But it highlights mechanisms that are probably at work in the economy -- big companies racing to avoid being disrupted -- and it shows how that could be the biggest driving force behind innovation. It’s something we often forget, and shouldn’t count out.

And these theorists aren’t the only ones asking whether big companies are the true creativity leaders. In recent years, economists have engaged in a vigorous debate over whether monopolies -- which by definition are established companies rather than startups -- are more inventive than other companies. Monopolies, with their fat profit margins, have lots of resources to spend on innovation, and they certainly have a huge incentive to defend their position in the market.

For example, economists Ronald Goettler and Brett Gordon theorize that the threat of Advanced Micro Devices forced chip maker Intel to dramatically increase its own rate of innovation. Intel preserved its dominant position, and as a result, Moore’s Law -- that computing power roughly doubles every two years -- continued apace.

So although disruption is essential to the healthy functioning of an economy, we shouldn’t forget about the crucial role played by corporate R&D. It’s fun to root for the underdog, but sometimes the challenger’s most important function is to make the champion play better.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

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