Saturday, November 22, 2014

Silicon Valley or Demand Mountain?

BELLEVUE, WASHINGTON – Everyone wants to know how to build the next Silicon Valley: an innovation hub that draws talent and capital, and that creates jobs, companies, and whole new industries. Developed-country governments scramble to subsidize technology that could be the Next Big Thing. Emerging-market policymakers hope that incentives like tax breaks and free land will induce innovators to settle and prosper there. But most of these well-meaning schemes are missing an essential ingredient: demand.

Demand for innovation in specific areas of technology has been the common force behind all high-tech hot spots, as well as the most important inventions. Technological breakthroughs such as antibiotics and cars responded to a compelling need felt by a huge number of consumers. Government projects such as the United States’ Apollo program – intended to put a man on the moon – drove demand for more basic technologies (which are simply inventions that no one has asked for yet).

Silicon Valley itself was built on demand. The US Department of Defense put up tens of billions of dollars in contracts for microelectronics, a commitment that both paid down innovators’ risk and created an infrastructure that would support the growth of start-ups.

All demand is not created equal, though, and it is instructive to examine the differences.

Consumer or market-driven demand – the kind most of us think of when we hear the word – is far less predictable, and therefore much riskier, than state-sponsored demand of the sort that landed a man on the moon. Companies that depend solely on their products’ commercial appeal are limited in the kinds of innovations that they can safely introduce, because if one of their products fails in the marketplace, they may not survive to build another one. This is especially true of start-ups and small companies – the very players that everyone hopes will show up in the next-wave of Silicon Valleys.

Fortunately, by sponsoring long-term, targeted initiatives, governments can stimulate more predictable demand. The Apollo program gave innovators clearly defined goals and a roadmap for getting there: first put animals in orbit, then put people there, then send probes to the moon, then send people there.

Equally important, the government offered rewards for interim progress, not just ultimate success. Putting a monkey in space may not have been the most exciting achievement, but the government was paying for it, so it happened. A smart government creates guaranteed demand not only for the solution itself, but for the steps along the way.

Coupling intermediate technical milestones with guaranteed incentives enables companies to focus on problems that might take ten years or more to solve. It also motivates innovators from a variety of industries to take on complex problems that must be addressed by more than one kind of invention. The US Defense Department’s microelectronics initiative required not only new materials and circuits, but also new methods of fabrication. Because of the reward structure, these efforts could be coordinated, rather than pursued in isolation.

Unlike market-driven demand, which too often results in a winner-takes-all dynamic, state-sponsored demand creates an environment in which multiple solutions to technical problems can proliferate and coexist. The pioneers of microelectronics tried many strategies to supplant vacuum tubes, and they delivered a host of semiconductors and chip designs: germanium, silicon, aluminum, gallium arsenide, PNP, NPN, CMOS, and so on. Some of these research efforts were never implemented, but many found their way into specialized devices. The diversity of options allowed widespread adoption, paving the way for the digital revolution.

As with the microelectronics program, government incentives don’t have to line the road all the way to commercial success. At some point, companies will be ready to sell products, and market demand can take over. The US Department of Defense was the only customer for integrated circuits in 1962, but by the end of the decade consumers were buying transistor radios and pocket calculators in droves.

Likewise, state-sponsored demand should not take the form of subsidies to specific technologies or companies; the government has no business gambling taxpayer money on particular ventures. Assuming that risk is the job of venture capitalists and others in finance, not public officials. But there is little risk in offering a contract for a job well done: there is no payout if the problem remains unsolved.

And those payouts are modest compared to the research and development efforts they stimulate. A program offering rewards of $1-5 billion in contracts or deployment commitments can generate many times that value in private-sector R&D. Innovators and their investors are willing to bet big on these opportunities, because they know that the eventual reward in revenue from a global customer base will far exceed the initial investment. That makes state-sponsored demand a very efficient mechanism for generating innovation.

Because of the multiplier effect, small governments and states, and even large cities, can successfully sponsor the kind of demand that fosters a world-class innovation epicenter. Certain Scandinavian countries, Chinese provinces, and the city-state of Singapore, for example, are ideally positioned to try this approach.

Some years ago, I calculated how many units of product need to be sold to launch a technology. The number is actually quite modest: If you can move between 100,000 and one million units of a disruptive product, you can establish the technology standards for that category and in time become the global leader of a new industry. Government sponsorship ensures that a certain number of people will adopt your product. At the start, it need not be that many.

The economic planners and policymakers who are chasing Silicon Valley’s taillights are learning that they cannot always replicate the entrepreneurial culture and finance mechanisms that flourish there now. But they have forgotten how it all started: guaranteed demand, which stimulates the most ambitious kind of innovation.

The lesson is a simple one: Don’t try to build another Silicon Valley. Instead, build a Demand Mountain, and the innovators will come.

Read more from our "The Innovation Revolution" series.

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    1. CommentedLewis Perelman

      I think this is a little naive, maybe anachronistic re the role of government acquisition. The latter may have been useful in the past, but it has become bloated, wasteful, and often corrupting. Dependency on government contracting poorly prepares and even undermines a firm's capabilities to respond to consumer demands and to function in commercial markets.

      DOD? Consider:

      The P-51 Mustang, the premier fighter aircraft of World War II, went from a sketch to full-scale production in about 18 months. The cost of each airplane to the government in today's dollars was about $660,000.

      The new F-35 Lighting II will have taken about 20 years from the time of its first development contract until initial delivery scheduled for 2015. By combining the functions of several aircraft in one, the F-35 was supposed to save the US and other nation's defense departments money. But the costs of the program have mushroomed while the aircraft's performance has been fraught with problems. The projected cost per airplane has doubled from $81 million to over $160 million...and rising. ( )

      Or this: The total cost of the legendary Manhattan Project which created the fist atomic weapons during World War II was about $24 billion in today's dollars. Today, the cost to the government just to dispose of 37.5 tons of unneeded warhead plutonium is about the same, or a bit more. ( )

    2. CommentedNathan Coppedge

      I have tried marketing my idea of a knowledge generator calculator to Texas Instruments, and with no response. For those that like this idea, you can contact me on twitter or go the cheap route and try to research categorical deduction without my advice.

      The book that announced categorical deduction was published this year: The Dimensional Philosopher's Toolkit (2013).

    3. CommentedDallas Weaver, Ph.D.

      In watching government funding in my narrow area of aquaculture, I have observed that gov't support seems to go to the best government connections, not to the best technology. I have watched some companies win contract/grants after contract/grants with masterful proposals, while producing little innovation and spending huge amounts of OPM (other peoples money). I have watched some non-profits (who pay better that profitable originations in this field) who just rip off ideas and concepts from other small firms and claim that these are their innovations, while having a congress directed funding line and 15 lawyers on their staff to destroy any of those who got riped off.

        CommentedLewis Perelman

        Dallas, yes, this is otherwise known as "crony capitalism."

        Here is an egregious example of someone who made millions selling a completely useless device to government security agencies:

    4. Commentedde Lafayette

      {Fortunately, by sponsoring long-term, targeted initiatives, governments can stimulate more predictable demand.}

      Not always, and not everywhere.

      I recall in the 1970s/1980s that France and the UK desperately wanted to beat the Americans into exploiting Information Technology. Their governments splurged on domestic companies inciting them to develop new products.

      It all came to naught, because the companies in question became very quickly "also-rans" in terms of innovative IT solutions. Why?

      For the most part because they were competing against American companies who were developing products for a very large US-market. They then transferred that technological knowhow to Europe by opening foreign subsidiaries.

      I was part of that effort ... I also worked in a part of France that was called the Silicon Valley of Europe. None of the American companies (including IBM) still have offices there.

      So, what happened? Europe demonstrated that government-supplied investments sometimes go quite wrong because they don't meet the match of customer requirements for goods and services.

      Just because some political functionary wants to show that s/he is "doing something", does not at mean that it work and produce entire new industries.

      Otoh, sometimes, big Industrial Oaks out of little acorns grow. A testament to that fact is Airbus that has challenged Boeing in the commercial aircraft market. It was no start-up, but, then neither was Boeing. And commercial aircraft technology is not exactly the "cutting edge" - carbon-fiber technology included.

    5. CommentedGunnar Eriksson

      Mr. Jung reminds us about something we already know but have hidden below many layers of neglect and focus on quarterly profit for the few.
      The "Green Revolution" is a good example of a "Demand Mountain" that resulted in considerable increase in food production. The UN played a central role in this effort, but also with national and private participants.

      The tasks ahead are not so hard to pinpoint;
      -Sustainable energy production and usage
      -Cures for the most pressing ailments
      -Sustainable water usage and food production

      As the market economy has failed to show progress in such vital areas we should look for public initiatives.
      The UN is best placed to lead and need fiscal capacity, (a financial transaction tax would serve the purpose).
      The "Demand Mountains" should seek both National and private participants and tax incentives for individuals should be considered.

    6. CommentedAurelian Dochia

      You certainly have a point here: demand created by governments provide a big stimulus for innovation. The problem is with the real-life implementation of government sponsored projects that have a multiplier effect. I hardly see a developing country government having the resources to initiate and manage an "Apollo" project! Too often, governments tend to engage in pharaonic projects that lead to nowhere and there are many examples of such failed endeavors all over the world.
      Government created demand is only a part of the equation. It can foster innovation if the rest of the economy is prepared to deliver. Silicon Valley is nurtured by many factors, like California universities, the size of the US market etc., which cannot be replicated.