Midwest Economy Blog

Innovation: Measurement and Policies

April 21, 2008

It has become almost hackneyed to proclaim that we live in a knowledge economy driven by innovation. The mantra of current economic development gurus is that the race goes to the smartest and the swiftest. Yet, despite this popular consensus that innovation may be the key factor in determining future growth in the economy, we actually know very little about how to measure innovation and what policies might influence innovation.

To begin with, we need a definition. Most definitions of innovation begin with “big bang” product innovation that alters the course of economies and enhances the quality of life. The invention of the light bulb and the airplane, as well as biotech breakthroughs, are just a few examples. But large gains are also made through process innovations that are often more subtle. The application of information technology to banking and financial firms and the advent of inventory and logistics management in retail trade come to mind. These process innovations change the efficiency with which inputs are used while vastly increasing the scale of output. This leads to goods and services that are faster, cheaper, and better. In fact, when the Chicago Fed studied the turnaround in the Midwest economy in the mid-1990s, we concluded that part of the region’s success was based on improving the efficiency of the existing economic base. Innovation in traditional industries explained much of the turnaround, rather than the creation of wholly new industries or products.

In January 2008, the Advisory Committee on Measuring Innovation in the 21st Century Economy issued a thoughtful report on how we might define and measure innovation. The report postulates that, while innovation is critical to the economy, “the nexus between innovation and growth is one of the least understood areas of economic life.” To bring clarity, the committee defined innovation as “the design, invention, development, and/or implementation of new or altered products, services, processes, systems, organizational structures, or business models for the purpose of creating new value for customers in a way that improves the financial returns to the firm.” The report then set about suggesting proxies for measuring innovation.

The committee rejected the notion of coming up with a single, all encompassing measure. Given that the economy and individual firms do not innovate the same way at the same time, the committee felt a single measure would lead to policy distortions. For example, it might be inappropriate to legislate public policy supporting an industry or firm that is going through a rapid period of innovation over an industry whose innovation breakthrough might be several years away. However, the report suggests a clear starting point by emphasizing that we need a better measurement of total factor productivity (TFP)—the change in productivity left over after accounting for the growth in labor and capital. Total factor productivity does provide a measure that can be augmented and refined by several policies to expand data collection on firm investment in key factors such as research and development, technology, and human capital.

So what policies did the Committee specifically suggest? Here is just a partial list:

  • Develop annual, industry-level measures of total factor productivity by restructuring the National Income and Product Accounts of the United States (NIPAs);
  • Create a supplemental innovation account for the NIPAs in order to expand the categories of innovation inputs and allow those inputs to be tracked as they flow between industries;
  • Improve service sector data and increase survey coverage to provide the data needed to improve estimates from the integrated gross domestic product/productivity accounts and supplemental innovation account;
  • Improve measurement of intangibles, particularly intellectual property; and
  • Better leverage existing data and increase access to enhance research on innovation.

In addition the committee recommended the business community:

  • Institute firm-level measurements of innovation to test the correlation on firm performance; and
  • Develop and implement best practice in innovation management and accounting.

Another interesting local approach is a new innovation index developed by the University of Michigan at Dearborn’s Center for Innovation Research. This index tracks six subindexes that reflect the state of innovation in Michigan and will be reported on a quarterly basis. The six measures are:

  • Trademark applications,
  • Innovation workers (measured as a percentage of the labor force),
  • Small Business Administration (SBA) loans,
  • Venture capital,
  • Incorporations, and
  • Gross job creation.

The index is benchmarked to 100 for the first quarter of 2007. The most recent reading of the index is 95.8.

These efforts at measuring innovation in the economy continue to be a messy process, but the potential dividends of better understanding and calibrating the role of innovation in economic growth is certainly an important step forward. Hopefully better innovation metrics will help guide policymakers and business leaders to make appropriate investments that will strengthen economic growth.

The Department of Commerce continues the dialogue by hosting a summit in Chicago on May 22 discussing actions to be made to secure America’s competitiveness.

The views expressed in this post are our own and do not reflect those of the Federal Reserve Bank of Chicago or the Federal Reserve System.

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