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What Drives Innovation?

After decades in the wilderness, industrial policy is now being rediscovered as a tool for addressing climate change and navigating a fraught new geopolitical environment. This development is long overdue, and fully justified by economic history since the dawn of the Industrial Revolution.

CAMBRIDGE – “Make a better mousetrap,” Ralph Waldo Emerson once wrote, and “the world will make a beaten path” to your door. The economics of innovation is central to understanding the dynamics of economic growth. Its focus is on how entrepreneurs and those who finance them address two fundamental challenges. The first, which has commanded the most attention among academics and the popular press, is technological. As my old boss, Pike Sullivan, Chairman of F. Eberstadt & Co., used to ask: “If you plug it in, does it light up?”

But as important as that question is, the second question for innovators and investors is key: Even if it lights up, does anyone care? Or, as I used to say to entrepreneurs looking for venture capital: “Tell me exactly whose problem you propose to solve. How many of them are there, do they have budgets, and how do you propose to find them when they don’t beat a path to your door?”

The leading academic approach to modeling the innovation process puts success in overcoming technological risks up front. The Schumpeterian theory of growth that Philippe Aghion and Peter Howitt have advanced over the past 30 years hinges on the competition to invent new, cheaper, faster, better intermediate goods that are needed for final products that are already in demand. Market risk does not enter into the analysis. Yet, regardless of where the locus of innovation is found, the importance of market risk has been apparent from the deep history of the First Industrial Revolution through the current digital age.