(This essay was published in Hong Kong Economic Journal on 27 January 2016.)

 

Economies grow when people can produce more output with the same amount of input. People can become more productive in two ways. First, they can innovate to find new ways of getting more or better output from the same input. Second, they can find new things to do. Most of the time innovation entails a minor tweaking of the old way of doing things, but on occasion it can generate a revolutionary change. The iPod device was a modest improvement over many MP3 devices but it transformed the Apple business and impacted most people’s lives.

 

There are two economic views of how innovation comes about.

 

Harvard Professor Joseph Schumpeter (1883-1950) emphasized the role of the entrepreneur as an innovator in capitalist economies. His theory is that competition among firms and industries drives invention and discovery. Creative individuals seek out new ways of doing things and new things to do in order to increase profit margins and improve their living standards.

 

Schumpeter describes the act of innovation to replace old technologies as “creative destruction.” This process is driven by the inevitable copying of new technologies, which causes profit margins in the creator firms to fall and creates fresh incentive to seek out new innovations. In the process some old firms will be replaced to make way for new ones.

 

Chicago Professor Frank Knight (1885-1972) held a different view. He distinguished between economic risk and uncertainty. Situations with risk are those where the outcomes are unknown but governed by probability distributions known at the outset. In situations of uncertainty, both the outcomes and the probability models that govern them are unknown.

 

Knight’s distinctive idea is that risk is insurable, but uncertainty is not. Profits earned by the entrepreneur are his reward for choosing an uncertain environment. The entrepreneur finds new things to do, new ways of doing things, or does old things in a new environment – all of which can involve uncertainty. Knight argued that uncertainty gives rise to economic profits that competition cannot eliminate.

 

To put all of this another way, for Schumpeter an entrepreneur is a competitive innovator and pioneer. The Silicon Valley model of innovation and economic growth best exemplifies the Schumpeterian model of capitalist growth. It is a development path built on an abundance of entrepreneurial and technological talent (either domestically nurtured or imported from abroad) that have access to a vast unfettered market economy (either domestically or globally) and work in a free environment with facilitating economic regulation, easy information access, and cultural lifestyles conducive to innovative pursuits.

 

For Knight, an entrepreneur thrives on making market choices in an environment of uncertainty. In bearing uninsurable risks, his success in the market is not merely a product of his personal attributes, but depends also on his positioning in the economic network and relationship to others in that network.

 

The idea that an entrepreneur is partially created by this position in a market network and his relationships to other producers and consumers is empirically convincing and compelling. Entrepreneurs seek market niches to maximize profit and minimize competition, but operate in a market over which they have very diffuse knowledge and hardly any control. Market niches may appear as a small part of the market network, but the examples below will demonstrate that companies operating in these small niches can be very large.

 

In fact, Knightian entrepreneurs act less in response to actual demand than by anticipating it: they gauge where competitors have found demand and thus determine what they can do that is similar and yet different enough to carve out a special niche. Products, prices and profits are determined by the coalescing of both niche and network-wide factors.

 

There are many examples of huge companies that have filled small niches in the global market network. Uber is the largest taxi company in the world today yet it owns not a single vehicle. Airbnb is the largest accommodation business for travelers but owns no accommodation units. If you were to examine their activities on the ground closely, you would find that their services and operations are not homogeneous from location to location.

 

Hong Kong’s DHL became a highly successful international airfreight forwarding and express service company without first owning a single airplane. Li & Fung started as a highly successful supply-chain management company without first owning a single manufacturing operation. Similarly, their services and operations are not homogeneous from location to location.

 

The market (domestic and global) must be thought of as a network, where individuals and firms and businesses and governments are connected through various relationships concerning supply, demand, sales, operations, financing, legal compliance, dispute resolution and other matters.

 

An innovative business is one that succeeds in creating an epidemic that sweeps  through the network from its small niche and impacts multitudes of relationships, reconfiguring them forever. It is a process described in Malcolm Gladwell’s popular book The Tipping Point: How Little Things Can Make a Big Difference (2000).

 

The “tipping point” is the central threshold for change in the social network of relationships. When mapped to an analogous economic network, it can be seen as the revolutionary act of innovation that transforms the business and impacts people’s lives. The ideas in Gladwell’s book were directly inspired by the research of Mark Granovetter that could be traced through his teacher Harrison C. White all the way back to Frank Knight’s views of entrepreneurship and uncertainty.

 

Gladwell’s book describes three characteristics necessary for having a tipping point – first, contagiousness; second, the fact that little causes can have big effects; and third, that change happens not gradually but at one dramatic moment. Successful tipping points need three kinds of people whom he calls “mavens, connectors, and salesmen.”

 

Mavens are people who accumulate information obsessively on a lot of different products, prices, and places, and connect people to the marketplace. They like to initiate discussions with customers and respond to requests. They are not merely experts, but experts who like to help you with your decisions. They are socially motivated, wonderfully unselfish, and enjoy being teachers. People therefore listen to them and trust them as honest information brokers who care about you.

 

Connectors are those people with a very large social circle. They have weak ties to a lot of people, which is what is needed to spread or gather information. Connectors are important for the transmission of information.

 

Salesmen have the skill to persuade people when they are still unconvinced. Persuasiveness is a subtle skill, employing both verbal and non-verbal methods of expression, to engage others morally, spiritually, and emotionally.

 

Entrepreneurship has many dimensions. Schumpeter’s insight is to focus on the necessary attributes of the entrepreneur and his innovations. Knight’s insight is to focus on nature of entrepreneurial action to locate a niche within a vast market network, over which he has neither control nor full knowledge.

 

Whether a country, a region or a city can become highly entrepreneurial would depend on the confluence of factors at play – either Schumpeterian or Knightian. A large, high-income, free-market, private capitalist economy like the US faces a very different set of conditions compared to the large, middle-income, socialist market economy of Mainland China. And a high-income, free-market, private capitalist, city economy under “one-country, two-systems” like Hong Kong is in a very different set of circumstances compared to either of these places.

 

Hong Kong’s current ecosystem for supporting innovation is quite good except for factors that can ultimately be traced to its small size and lack of scale. These drawbacks ultimately are the result of a lack of human capital to provide throw-weight to drive an innovation-led economy forward.

 

And what attributes do economies need for innovation and entrepreneurship to thrive? Government policies to encourage entrepreneurship do not really differ whether one believes in Schumpeter or Knight. What do matter, however, are the following:

 

First, a free and open economy and society.

 

Second, investment in human capital and in attracting human capital talent from the rest of the world.

 

Third, upholding the rule of law and protecting intellectual property rights.

 

Fourth, maintaining a business regulatory regime that lowers barriers to entry for startups and new companies.

 

Fifth, supporting the development of telecommunications infrastructure to make information access cheap and convenient in the digital age.

 

Sixth, facilitating financial and managerial support for startups.

 

Seventh, developing infrastructure for basic and applied research.

 

Few countries, regions or cities have an abundance of these attributes and the resources or the ability to create them. Resource scarcity compels us to tailor our policies to focus on what would work best.

 

According to this list of attributes, my assessment is that Hong Kong is one notch behind the U.S. primarily because of its lack of scale in human capital and research infrastructure; in these areas it also falls behind Mainland China. Our government cannot address these shortcomings because they are tied to the size of the population and the economy when compared against the U.S. and Mainland China.

 

Mainland China has an enormous advantage in scale and this will compensate for its weaknesses in other areas of entrepreneurial fitness. Still, it will continue to punch below its weight if the other critical attributes cannot catch up. Scale and entrepreneurial fitness are highly complementary and both are needed to repeat the success of a Silicon Valley.

 

Both Israel and Singapore are comparable in size with Hong Kong, but these two countries have had the advantage of a massive immigration of talents from abroad in recent decades. Our city was not blessed with such an advantage. Of course, Hong Kong’s growth benefitted from the massive immigration of talents from the Mainland shortly after World War II. But this experience is unlikely to be repeated again. Hong Kong will have to build on its other advantages, which are still very considerable.

 

The Silicon Valley model has been the dominant model of innovation-led growth. It is largely the Schumpeterian model. Many countries have sought to repeat its success through government policy, but often with much less success if not outright failure. One of the missing factors is that no economy in the world is close to the US in terms of both scale and entrepreneurial fitness. This means that no economy can repeat its success, not even Mainland China with only a scale advantage.

 

Hong Kong does not have scale. So she has to take a page from the Knight model and position her business innovations in niches in the global economic network so as to maximize profit and minimize competition. She has to mobilize all the knowledge of her networked people and their partners to act as mavens, connectors and salesmen in finding the right niches to build innovative businesses. Hong Kong’s people will have to approach innovation and startups with their brains, passion, and integrity. In knowing how to speak the language of business that everyone in the world speaks, she can play host and hub in connecting her partners. Connecting China to the world and the world to China will be one of the outcomes.

 

 

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