Rethinking Trade and Innovation for the Digital Age

he principle that institutions matter is widely accepted, promoted by the Organisation for Economic Co-operation and Development, the World Bank and other international organizations.  New institutional economics (NIE) has become a respected academic field, legitimized by Nobel Prize winners, and known for its leading methodology — transaction cost analysis.² NIE focuses on relationships and decision making at the level of the firm or organization, rather than the statistical aggregates of mainstream economics.

Transaction costs include the less tangible costs of identifying needs and searching for solutions and evaluating products — and the practical costs of delivery, reliability, risks and maintenance that follow. This can be a long, ongoing process, especially in the context of business relationships within a supply chain where there are uncertainties, both upstream and downstream. Such contracts are bound to be complex but incomplete. They are adjusted over time as external conditions, and new opportunities, are revealed. (These transactions are not the individual purchases routinely made by consumers.) A good contract tries to anticipate change, but there are intangible elements in a business relationship, such as trust and evolving business interests, that cannot be specified in advance.³

In the background, the classic binary decision persists: Should the firm make, or buy? Should it produce a necessary component itself, and save the costs of transacting? Or should it look to the market to find the best possible supply? Should the firm look for a better supplier or a second source, or solve problems by buying out the supplier?

National institutions, notably laws, govern and support transactions and the organization of economic activity. Conversely, the practical economics of transacting should inform the rules of commerce. The design of fixed institutions such as patents, competition law, tax, privacy, subsidies and trade shapes economic behaviour over the long term (as distinct from short-term measures such as monetary policies and public spending).

Transacting across Borders

The question of locating production inside or outside the firm is paired with the question of locating production inside or outside the country. Supply chains that cross national borders become global value chains. As globalization has progressed, the relatively “hard” transaction costs of tariffs, transportation and communications have been reduced. Less tangible barriers — national standards, legal and regulatory differences and language — have also diminished. Until the financial crisis, world trade and foreign direct investment grew substantially relative to GDP.

Trade is a well-developed branch of economics in which specialization, scale economies and comparative advantage play recognized roles. Unlike NIE, trade is highly visible and easy to measure. Borders are well-defined; cross-country comparisons are routine. Perceptions of legal systems, political stability, transparency, corruption and trust are surveyed. All of these factors inform the make-or-buy, foreign-or-domestic decision matrix — alongside costs of production, benefits of specialization, investments required of the supplier, potential for learning and supply chain control. This is more a matter of orchestrating relationships and global strategy than it is tractable economics.

Transacting for Innovation

Analogous to global value chains in trade, the idea of “open innovation” maintains that innovation should be less restricted to in-house research and development (R&D) and should focus more on the acquisition of knowledge and technology from outside the firm (Chesbrough 2003).⁴ As in trade, there are benefits to specialization and the ability to draw on the best information, knowledge and human capital from anywhere in world. As expressed by Bill Joy, co-founder of Sun Microsystems, “no matter who you are, most of the smartest people work for somebody else.” Given the intangible resources needed for innovation, relationships can take many forms, including: non-exclusive licensing, acquisition of patents and/or trade secrets, cross-licensing, consulting arrangements, pooling of intellectual property, joint ventures, standards development, contracting for R&D and acquisition of start-ups.

Compared to mature industries with component supply chains, innovation-oriented firms must contend with higher levels of uncertainty, although uncertainty diminishes as ideas are tested, proven, refined, implemented and, eventually, face the market. Innovating within the firm has the advantage that everything within its boundaries is (at least in theory) under common ownership and control, and while internal negotiations may be more complicated than for routine production, disagreements can be resolved by executive fiat. The firm can also choose to acquire a company that has the desired technology and expertise, and so curtail further transacting (although there may be intangible costs in assimilating an enterprise that has a different culture). 

Innovation can be complicated by the core institutional framework for innovation, patents, which offer a telling example of the relationship between institutions and transactions. Patents are negative rights to exclude others, and not, as is often assumed, a right to exploit the technology. Even in technology developed wholly within the firm, underlying rights may belong to someone else. When patenting is pervasive, as it is in digital technology, it becomes very costly to evaluate ownership and to negotiate licenses.⁵

Like neoclassical economics, the patent system does not acknowledge transaction costs. Moreover, it operates on the premise that one size fits all. While strong exclusion is well-fitted to the high costs of bringing valuable molecules to market, the rich functionality and high degree of interdependence in information technology imposes heavy transaction costs. The problem is manifest in the estimate of 250,000 possibly patented functions related to smart phones,⁶ a volume that imposes a heavy cognitive burden on innovators — especially relative to the diluted value of individual patents when there may be hundreds or thousands embodied in a single product. This drives demand for specialized lawyers as intermediaries, who, in turn, benefit from the transaction costs and the volume.

Through bilateral cross-licensing, incumbents are able to contract around both the transaction costs and the need for licenses. However, the environment has been further complicated by the rise of patent assertion specialists (or “trolls”), who do not need cross-licenses because the fact that they produce nothing makes them invulnerable to the patents of others. The largest companies fight back with overwhelming legal resources, inducing assertion specialists to litigate against smaller firms that are less able to mount a vigorous defence. So the high cost of legal disputes — a major transaction cost in terms of direct outlays and risks — can become both a defensive and offensive weapon. Although individual patents can still be of value to small firms, the net effect is to tilt the playing field against small firms in favour of large firms — all the more so because patents are territorial and must be secured (and enforced) in every jurisdiction where protection is sought.

Digitization

Digital technology is not just a field of technological innovation; it permeates the entire economy as a general purpose technology. It has played a major role in reducing transaction costs such as searching, communications, documentation, advertising and maintaining economic and social relationships across time and space. The internet has provided a universal platform for globalization, which, in turn, has enabled economies of scale and specialization for digital technology, advanced miniaturization and led to exponential improvements in performance, network effects and low-cost access. Yet barriers based on territory persist, preserving transaction costs and inhibiting scaling. Patents, taxes, competition laws, consumer protection, privacy laws, regulation of services and so on, are all territorial, which mattered less in a pre-digital, less global environment.

Like transaction cost analysis and institutional economics, digitization and globalization push and pull at the conventional framework of firm-level microeconomics and nation-level macroeconomics. Digitization pushes from below, challenging the standard economic measures, and raising questions about what value is missed in statistics. Digitization expands the significance of transaction costs by showing how a reduction in transaction costs works at the consumer level, leading to virtual stores with millions of apps, long-tail markets such as eBay, resource-sharing platforms such as Airbnb, and the extended ecosystems of Google and Amazon.

Digitization has created new innovation paradigms that are especially suited to environments where production costs and entry barriers are vanishingly low, rapid and widespread adoption is possible, and the technology enables further innovation, new uses and personal expression. Prominent examples include the internet, the World Wide Web, most software standards and open-source software. In these cases, public funding, academic collaboration, certain business models and volunteered human capital combine to enable “permissionless” innovation, in which the transaction costs of search, negotiation and distribution are nearly eliminated.  

Diminishing costs of transacting, production and entry are mutually reinforcing. Evaluation costs are reduced by the comments of individual users in forums, mailing lists, wikis and blogs. Smartphone platforms have made it easy to develop apps using published APIs (applications programming interfaces) and SDKs (software development kits). Cloud services have lowered barriers for small businesses by eliminating the need to invest in hardware and software.⁷ Advertising provides an alternative to conventional production and distribution models. “Free” becomes a viable price as attention becomes a scarce resource. And there are transaction benefits: clicks and “likes” as signals of value; free trials for software and other experience goods⁸ that may lead to paid transactions; and successful transactions leading to long-term relationships.

New Institutional Economics

Digitization has played a major role in bringing down barriers, supporting transactions across borders and trivializing the cost of remote communications. The institutional environment is now determined less by the laws of the nation-state and more by the overarching political economy of globalization. This includes international institutions such as the World Trade Organization, the International Monetary Fund and trade agreements, but also geo-economic phenomena such as global value chains, visa-free travel, migration and the many networks — economic and social — riding on the internet. True, the advance of globalization has stalled relative to GDP, but it has evoked a populist reaction that aims to “take back control” and promote national interests with limited appreciation for economic interconnectedness.

There is another change: internet platforms engaging millions of users have become institutions in their own right, managing markets, implementing policies and shaping economic exchange and social interaction. They have become the most valuable companies in the world, with an intimidating aura of invulnerability and permanence, while serving as essential infrastructure for individuals, start-ups and small and medium-sized enterprises (SMEs). Unlike globalization, digitization does not present an easy target for political reaction; however, foreign tech giants do. They have pushed envelopes on many fronts — copyright, privacy, tax, competition law and regulation of services — where they often meet resistance. This is especially the case in Europe, while China has effectively walled itself off.

How does a mid-sized country develop a national strategy, if not a policy, in this world of economic giants and diminished political leadership? How does it advance its domestic enterprises in this unfamiliar environment? Can it answer the conundrum of digital inequality, the distance between the Facebook business page and Facebook infrastructure? The conventional wisdom is that cloud services, open-source software and niche opportunities provide a breeding ground for billion-dollar “unicorns” that will be snapped up by competition among the agents. How common or real are unicorns? Is Facebook the last of the giants? Is there still an organic path to the top? 

There are a number of options:

• Reducing transaction costs: Cities, clusters and regional corridors help reduce the transaction costs of human interaction, especially the exchange of tacit knowledge.  Education, training and learning by doing also help reduce knowledge-related transaction costs over the course of a lifetime. These benefits are often combined in strategies for regional development, but the positive externalities and feedback loops (often amplified by digitization) are hard to measure. Costs and benefits are too often calculated just on direct revenue and expenditures.
• Exploiting opportunity: There may be concrete niche opportunities in national policy/strategy, just as there are for SMEs. This is usually framed in terms of opportunities in upstream scientific research that may be pursued anywhere in the world where human capital and resources are gathered in critical mass. It may make sense to focus on opportunities to break down institutionalized thinking by exploiting local culture, climate or political conditions. Research on cannabis may be a candidate, given the political paralysis that exists in most places, including the United States. The inventor ownership policy of the University of Waterloo is unique in North America, demonstrably successful (especially for digital technology) and merits possible adaptation elsewhere (Kenney and Patton 2011).
• Experimentation: Failure is a mark of experience in Silicon Valley, but a stigma in government. However, the risks involved in policy and programmatic initiatives are often accepted at the local level, where it is easier to develop consensus and there is less risk of entanglement with partisan politics. Digitization of publicly supported services is a relatively easy bet, and successes can often be amplified through sharing with other locations.
• Rethinking trade and innovation policies: The lesson of institutional/transactional economics is that there is space for original thinking both below and above the conventional micro-to-macro economy. There is the new transactional (or subtransactional) level of exploiting digitization and, on the upper end, a new political economy in which former thought leaders appear enamoured of autarky, popular will and evidence-free policy making. In this expanded strategic space, perhaps policy should enjoy the excitement and creative thinking that digitization has brought to the private sector. Legacy assumptions can be reconsidered in light of digital empowerment, expansive digital ecosystems and the deficiencies in conventional leadership.