In Praise of Lesser Evils
Can Realism Repair Foreign Policy?
Most explanations of economic growth focus on conditions or incentives at the global or national level. They correlate prosperity with factors such as geography, demography, natural resources, political development, national culture, or official policy choices. Other explanations operate at the industry level, trying to explain why some sectors prosper more than others. At the end of the day, however, it is not societies, governments, or industries that create jobs but companies and their leaders. It is entrepreneurs and businesses that choose to spend or not, invest or not, hire or not.
In our research on growth, therefore, we have taken the opposite approach, working not from the top down but from the bottom up, adopting the perspective of the firm and the manager. From this vantage point, we have learned that different types of innovation have radically different effects on economic and employment growth. This insight gives entrepreneurs, policymakers, and investors the ability to collaborate as never before to create the conditions most likely to unlock sustained prosperity, particularly in the developing world. We argue that there exists a well-established model of company-level investment and innovation that leads to transformative economic development and national prosperity, has been remarkably consistent at explaining past successes, and can provide direction to stakeholders in what to look for and what to build in the future.
Our model targets innovation as the fundamental unit of analysis, since most investments are focused on that. And innovation, in turn, comes in three varieties. The first is what we call “sustaining innovation,” the purpose of which is to replace old products with new and better ones. Such innovations are important, because they keep markets vibrant and competitive. Most of the changes that one sees in the market are sustaining innovations. But these are by nature substitutive, in that if a business succeeds in selling a better product to its existing customers, they won’t buy the old product anymore. When Samsung releases an improved model of its flagship smartphone, sales of its old versions drop quickly. When Toyota convinces consumers to buy a hybrid Prius, they don’t buy a Camry. Investments in sustaining innovations, therefore, rarely create much net growth within the companies that develop and sell them. And rarely do they lead to new jobs to fuel macroeconomic growth.
“Efficiency innovation” is the second type; it helps companies produce more for less. Efficiency innovations allow companies to make and sell established products or services at lower prices. The Walmart retail model, for example, is an efficiency innovation. Walmart can sell the same products to the same customers as a traditional department store, such as Macy’s, does at prices 15 percent lower and with half the inventory. In every competitive economy, efficiency innovations are critical to companies’ survival. But by their very nature of producing more with less, efficiency innovations entail eliminating jobs or outsourcing them to an even more efficient provider. In addition to being able to produce more with fewer people, efficiency innovations make capital more efficient, improving cash flow.
The third type is “market-creating innovation.” When most industries emerge, their products and services are so costly and inaccessible that only the wealthy can buy and use them. Market-creating innovations transform such offerings into products and services that are cheap enough and accessible enough to reach an entirely new population of customers. The Model T Ford, the personal computer, the smartphone, and online equity trading are examples of market-creating innovations. Because many more people can buy such products, the innovators need to hire more people to make, distribute, and service them. And because market-creating innovations are simpler and lower cost, the supply chains that are used for sustaining innovations don’t support them. This makes it necessary to build new supply networks and establish new distribution channels in order to create a new market. Market-creating innovators create new growth and new jobs.
Market-creating investments require two things: an entrepreneur who spots an unfulfilled customer need and the presence of an economic platform (that is, an enabling technology or feature in the product or business model that brings significant advantages in economies of scale). Kenya’s M-Pesa service, for example, has succeeded in addressing the lack of consumption of banking services across the country by using a wireless telecommunications platform. When M-Pesa was released in 2007, fewer than 20 percent of Kenyans used banks; today, more than 80 percent do. The South African telecommunications giant MTN, meanwhile, ushered in the cell-phone revolution across the continent by combining telecommunications infrastructure with low-cost phones targeted at nonconsumers.
Any strong economy has a mix of all three classes of innovation at any given time. But only market-creating innovations bring the permanent jobs that ultimately create prosperity. By targeting nonconsumption, market-creating innovations turn the liabilities of developing nations—the diverse unmet needs of their populaces—into assets. In the process, they create new value networks, build new capabilities, and generate sustained employment. This feeds a virtuous circle, as innovators move up the ladder to more sophisticated nonconsumption opportunities.
Our early research seems to show that market-creating innovation has been an important factor in every nation that has managed to achieve transformative growth and prosperity. Postwar Japan offers perhaps the best example. The Japanese economy was obliterated in World War II, so its challenge in many ways was less to develop from scratch than to rebuild. Japan’s success in that effort has often been attributed to national pride and a strong work ethic, to the vision of government agencies such as what was then the Ministry of International Trade and Industry, or to excellence in science and engineering education. But such explanations have lost their persuasive force as Japan’s economy has stagnated in recent decades: a constant cannot explain a variable. In retrospect, a more powerful explanation for the country’s postwar growth is its success with market-creating innovations in motorcycles, automobiles, consumer electronics, office equipment, and steel.
Consider the Japanese motorcycle industry. From a group of more than 200 motorcycle makers in the 1950s, Honda, Kawasaki, Suzuki, and Yamaha emerged to captain the industry’s development at home and abroad. These “Big Four” firms did not seek growth by stealing market share from existing leaders in motorcycles. Rather, they targeted nonconsumption. When the Japanese Diet passed an amendment to the country’s Road Traffic Control Law in 1952 allowing younger drivers to ride motorcycles, Suzuki was one of the first companies to adapt its offerings for younger consumers, with its low-end 60cc Diamond Free bike. Similarly, Honda launched the 1952 50cc Cub F-Type to target the growing number of small businesses that needed delivery vehicles but couldn’t afford large ones. Honda positioned the motorcycle at the affordable price of 25,000 yen (about $70) and provided a 12-month installment financing plan. Domestic competition among firms vying for the business of consumers with little disposable income caused them to integrate backward in components and forward in distribution channels. This created jobs in Japan beyond the Big Four themselves, and it also gave them the ability to export their motorcycles to the United States and Europe and compete for new consumers in those markets as well.
The same pattern was seen with Panasonic, Sharp, and Sony in consumer electronics; Nissan and Toyota in cars; and Canon, Kyocera, and Ricoh in office equipment. They all followed a two-stage strategy of competing against nonconsumption in the domestic Japanese market first and then pursuing the same strategy abroad.
This model has been replicated in South Korea, where market-creating innovators, such as Samsung, which have been pivotal to the country’s economic rise, studied the Japanese experience closely. Samsung was founded as a trading company but launched an electronics subsidiary in 1969 to manufacture products that would eradicate domestic nonconsumption of entertainment and cooling technologies. Samsung Electronics’ first product was a black-and-white TV, produced jointly with the Japanese companies NEC and Sumitomo. Soon after, Samsung studied Japanese models to produce some of South Korea’s first cheap electric fans, and then the company graduated to low-cost air conditioners. By launching a continuous stream of market-creating innovations, Samsung has become one of the most recognized brands in the world and one of the largest single contributors to South Korea’s GDP.
In China, too, market creators have built domestic niches into regional or global footholds, in industries ranging from consumer durables to construction equipment. Haier started out in 1984 as a market-creating innovator that produced mini-refrigerators for Chinese nonconsumers, and then it leveraged a partnership with the German firm Liebherr to acquire technology and equipment. By 2011, the company had disrupted many global incumbents in the “white goods” market with product lines inspired by its experience in China, gaining a global market share of 7.8 percent. Similarly, Sany was launched in 1989 as a small materials-welding shop for an underserved town in Hunan Province. It leveraged its understanding of local needs and the latest technological advances to produce cheap construction equipment for China’s booming construction market. Today, it has a higher domestic market share than its main rival, the U.S. firm Caterpillar, and is also gaining market share in foreign markets.
The same pattern appears in other countries as well. In Chile, government reform and the booming copper industry have received significant acclaim, but market-creating innovations seem to have been the true engine of growth. For example, the blossoming of Chile’s agriculture sector was based on market creation—before Chile’s innovations, nonconsumption of fresh fruits and vegetables was pervasive during most of the year in nontropical advanced countries. Chile’s agricultural exporters leveraged the improving science of cultivation and modern logistics to transform the availability of produce and provide fresh goods all year round.
In India, many health providers are embracing market-creating innovations to make quality health care more accessible. The Aravind Eye Hospital launched with the goal of providing low-cost eye surgery to poor nonconsumers. By introducing innovations such as the high utilization of medical staff and tiered service levels for paying and nonpaying customers, Aravind has become the largest eye hospital in the world. And just as in the Japanese case, Indian firms are using their domestic platforms to target nonconsumers abroad: Narayana Health, for example, is setting up shop in the Cayman Islands to reach cost-conscious Americans, and India has become a leader in health tourism, serving over a million foreigners every year.
And in Brazil, where extensive oil and lumber resources often capture attention, market-creating innovators such as Embraer have been hard at work creating jobs and capabilities. Like most aircraft manufacturers, Embraer was initially supported by government subsidies and focused on producing aircraft for military purposes. But the company trained its sights on the commercial market, delivering low-cost aircraft to domestic airlines. Today, Embraer has acquired a broad set of capabilities, has created extensive domestic supply networks, and makes planes for several dozen leading international airlines, including major U.S. ones, such as American, Delta, JetBlue, and United. And Grupo Multi, another Brazilian market-creating success, targeted the nonconsumption of foreign-language learning by developing a new model to teach Brazilians how to speak English. It now maintains over 2,600 franchised schools, has generated over 20,000 jobs, and has trained over 800,000 students.
Such examples suggest the wide range of opportunities available to grow by targeting nonconsumption and creating robust domestic franchises that can then achieve regional or global scale. Looking at things this way also sheds light on what role resources and investments actually play in development. Several ostensibly valuable levers for development—such as investments in natural resource industries, major infrastructure projects, and routine foreign direct investment—have rarely brought the benefits their backers expected. Why not? In part, because such investments don’t create markets.
Economists have long wondered why nations endowed with oil (such as Iran, Iraq, Mexico, Nigeria, and Venezuela) or precious metals (such as Mongolia, Peru, and Russia) generate billions upon billions in revenues and profits yet manage to create few jobs and little national economic growth. The answer is that investments in resource industries in developing nations lead to efficiency innovations, designed to produce more with less. From the day these rigs and refineries go into operation, the objective of their managers is to increase productivity by reducing employment. This is the logic of efficiency innovation, and its outcome is net job loss, not gain.
Many infrastructure projects, such as communications towers, power plants, and roads, meanwhile, are also efficiency investments. They reduce the cost of operations for domestic companies, allowing them to better serve their existing customers, but they do not directly lead to the creation of sustained growth and prosperity. In fact, if they cannot be combined with a different set of investments specifically targeting unfulfilled customer needs, their benefits will remain limited to existing customers and their economic impact will be limited as well. This is why infrastructure investments in developing countries, championed by organizations such as the World Bank and the International Monetary Fund, so often fail to drive long-term growth.
Most foreign direct investment, finally, is similarly oriented toward efficiency. The most common type is when a multinational company sets up a low-cost factory to provide components or services for products with an established end use. Often, these investments are “migratory”: as soon as the low-cost rationale for the investment in country X has played out, the company moves its factory to lower-cost country Y, if possible. These are investments to get things into and out of the country, not to develop a long-term, stable source of production and jobs.
Some types of foreign direct investment, of course, do bring more substantial benefits to developing nations. One example is when an investment supports a product that is creating a new market abroad. Typically, the market for the end products and services is growing faster than efficiency innovations are decreasing costs. Such an investment puts people to work to build and run the initial factory, and then the company keeps hiring additional employees to keep pace with customer growth. This distinction explains why foreign direct investment did not create fundamental growth in Mexico but did in Taiwan. Most U.S. investments in Mexico funded efficiency innovations embedded within established end-use markets—in industries such as automobiles, appliances, and electric motors. In contrast, most of the companies that have driven Taiwan’s economic development—including ASUSTeK Computer, HTC, Hon Hai Precision Industry, MediaTek, and the Taiwan Semiconductor Manufacturing Company—have provided efficiency innovations embedded within market-creating innovations: more efficient components or services used in market-creating innovations such as laptop and tablet computers and smartphones. Because the growth from market-creating innovations is typically greater than the rate of reduction caused by increased efficiency, the broader economy became more prosperous.
Given that most investments in developing economies have been conceived from the top down and have focused on efficiency, it should come as no surprise that there has been little growth in areas that seemed otherwise to possess such promise. To do better in the future, both the public and the private sector should work to support market-creating innovations—and innovators—in their home markets.
Perhaps the most critical move to boost market-creating innovation would be to put in place platforms and incentives that would accelerate the flow of capital between investors and market-creating innovators. Some of this work simply involves adapting existing tools to the particular challenges of investing in emerging markets. Online investment platforms, such as AngelList and Gust, which directly connect investors to entrepreneurs, have the potential to accelerate many market-creating investments (provided they can be adapted to address the legitimate trust concerns of investors), and both are already going global. So-called crowdfunding networks, such as Kickstarter and Indiegogo, can also be targeted more precisely at market-creating activity, with a particular focus on giving investors from developing countries’ ethnic diasporas the chance to invest. And in resource-rich nations, policymakers can play a bridging role by diverting a portion of the revenues from those resources toward funds specifically designated for market-creating investments. Such funds should be managed autonomously, by investors who understand how to spot and support market-creating innovations.
Most entrepreneurs focus on introducing products and services into existing, established markets, but market-creating innovation is built on targeting nonconsumption—unfulfilled needs in new markets. To help entrepreneurs tap the abundant nonconsumption opportunities available in developing nations, adequate training programs must teach entrepreneurs how to see such nonconsumption and estimate the rewards of eradicating it. In coordination with universities and companies, such programs should study how market-creating innovations have taken hold in comparable nations and identify emerging high-potential technologies. Several case studies are already available that can teach entrepreneurs the critical elements of market creation. For example, Godrej & Boyce’s chotuKool, a portable refrigerator—a disruptive product bringing affordable cooling capability to the 80 percent of rural Indian consumers without access to reliable refrigeration—shows how creativity and patience can bring life-changing products to segments of the market that had long assumed that such luxuries were beyond their reach.
A long-standing concern of entrepreneurs and investors trying to build businesses in the developing world has been the seemingly unavoidable roadblock of corruption. There is evidence, however, that systemic corruption can be circumvented. Thus, despite India’s high degree of corruption at all levels of society, information technology companies in its southern states have prospered because the Internet has essentially become a conduit around the corruption rather than through it. This principle holds promise for other businesses around the world. Rather than spending managerial time applying for or negotiating fees for certificates, licenses, permits, and registrations, executives should work with reform-minded leaders to create ways of getting them easily and virtually, bypassing the multiple opportunities for corruption along the ordinary routes.
For certain system-level constraints, finally, instead of waiting for the system itself to change, entrepreneurs are best served by trying to internalize the problem and control more of the outcome. For example, although traditional capital markets may not be keen on market-creating innovations, the concept of “royalty financing” could help individual businesses. Under this scheme, rather than raising traditional equity or debt, the entrepreneur can license investor capital. The investor receives nothing until revenues are generated, and then the entrepreneur pays a royalty to the investor—a percentage of revenues—just as is common with licenses for intellectual property. As revenues increase, royalties increase, until the accumulated royalties paid have reached some multiple of the initial principal amount. Such an approach precludes the need for a liquidity event, that is, an opportunity to cash out, whose outcome is hard to predict when capital markets are poorly organized and policed. Instead, investors benefit from a liquidity process, which they can monitor and confirm firsthand.
Skilled talent is even scarcer than capital, and here, too, companies can move to internalize the problem. By embracing in-house vocational programs or working more closely with schools and universities, companies can address the problem directly. At the extreme, in South Korea, the steel company POSCO set up its own university to train capable engineers. Observing that “you can import coal and machines, but you cannot import talent,” POSCO’s founder, Park Tae-joon, led the company to establish the Pohang University of Science and Technology to provide needed education in science and technology. The school consistently tops domestic and international university rankings and has been rated number one by the London-based Times Higher Education’s “100 Under 50,” a ranking of the top 100 universities under 50 years old.
Armed with a strong causal explanation for what provides sustained growth, and operating in supportive conditions and joined by sympathetic policymakers, entrepreneurs in developing countries can create new markets and new opportunities. The result of doing so will be not just successful businesses but also more broad-based job creation and more robust and lasting prosperity for their countries and fellow citizens.