Does Australia Really Need to Encourage its Innovators to Commercialise In-House?

by JOSHUA S. GANS Melbourne Business School University of Melbourne
First Draft: 17th November, 1997

It has become commonplace to open up the newspaper and read an article bringing news of yet another promising Australian innovation.1 Such news makes us all optimistic. The prospects that the Australian economy might have something more than a primary and service industry base bodes well for future prosperity. But alongside the reports of the innovation, comes calls from government officials and industry leaders for the opportunity not to be lost overseas. They are concerned that, if the innovation is not “commercialised” within Australia, the profits (or “value added”) from the promising idea will be lost. The tone of the statement indicates that innovation is not worthwhile without further stages of the production process being done by Australians, within Australia. In this paper, I wish to examine this concern in more detail. Indeed, I will argue that it is a matter of simple economics that this concern is, for the most part, misplaced. The path to maximising the returns from innovative activity lies not in commercialising and manufacturing innovations in-house but in exploring cooperative arrangements with overseas companies. This ensures that commercialisation is undertaken in the most economically efficient manner. Forward integration into the production process by inventors or local firms with little industry experience is usually not desirable.

1

A good example of this is the biosensor developed by the CSIRO. For a discussion of this case see J.S. Gans, “The inventive alternative,” Australian Financial Review, 12th June, 1997, p.19.

2 My challenge to conventional thinking is important because that thinking underlies most government policy on private innovation. In the last year, the Federal Government has embarked on several schemes to encourage innovation by business, in particular, small to medium enterprises. But often the funds available and concessions offered are explicitly targeted at projects that have commercialisation potential. Take, for example, the

“Innovation Investment Fund” administered by AusIndustry. That fund aims “to create a self-sustaining Australian early stage, technology-based venture capital market and to improve the commercialisation outcomes of Australia’s strong R&D capabilities.”2 Indeed, the guidelines for eligible investee companies explicitly favour Australian in-house commercialisation:
71.A licensed fund may only invest in eligible investee companies. For a company to be an eligible investee company, it must satisfy all of the following: a) it is commercialising the results of R&D activities or will, under the investment arrangement with the licensed fund, be required to commercialise the results of R&D activities. b) at the time the licensed fund first invests in the company, the company’s business activity, which the investment is intended to support and develop, is at the seed, start-up or early expansion stage of its development; c) it operates or proposes to operate in the traded goods and services sector; d) the product or service to which the commercialisation of the R&D activities relates is produced with the primary purpose of multiple sale to a variety of unrelated entities; e) it has a majority of its employees (by number) and assets (by value) inside Australia at the time the licensed fund first invests in the company ...

Moreover, foreign participation is discouraged:
76 g) Foreign investment: a licensed fund is not permitted to invest in a business if: i. the initial investment will be used primarily for a foreign operation; or ii. at the time of the initial investment, more than 49% of the employees or tangible assets of the business are located outside Australia (unless the licensed fund’s manager can demonstrate, to the Board`s satisfaction, that the investment was used for a specific domestic purpose).

The ventures most likely to receive funding are those that intend to commercialise innovations themselves. The irony is that, in many high technology industries, in-house commercialisation is the exception rather than the rule for small technology start-ups. In biotechnology, itself a model for small innovative companies, those firms, having patented their inventions, seek their returns not in direct manufacture but with licensing agreements with large, established
2

See the AusIndustry web page: http://www.ausindustry.gov.au.

3 pharmaceutical companies. Indeed, for InGen, the fictional biotechnology firm that was responsible for Jurassic Park, the implausibility perhaps lies less in the technology itself than with the fact that it attempted to bring the technology to market itself. Integrating with Disney would have been a more plausible commercialisation strategy given the common pattern in the industry. 3 But this pattern is also a feature of industries where intellectual property rights are relatively weak. In computer software, the prize for many start-ups is to develop software that is integrated into the established packages of major players. Indeed, Microsoft, despite being pursued by the US Department of Justice, is probably the single largest acquirer of small start-ups in the world. In this paper, I will discuss why outside rather than in-house commercialisation is the route to appropriating the maximal returns from innovation. In so doing, I will highlight the flaws in the direction of current government research and development policy and suggest a better and more profitable focus.

Two Paths to Capturing Innovation Returns

To illustrate my argument, it is useful to consider a stylised representation of the innovation and commercialisation process. Suppose that an Australian inventor has

developed a potentially useful innovation. The greatest returns are overseas and it is there that the inventor must look for markets. At this point they face two choices as to how they go about capturing the returns from innovation. One path would have them

commercialising the innovation themselves -- in-house commercialisation. That is, they invest in manufacturing, regulatory approval and any other task required to make the
3

For a further discussion of these cases see J.S. Gans and S. Stern, “Incumbency and Competition in Innovation Markets,” Paper presented at the Annual Australian Law and Economics Conference.,

4 innovation a commercially viable product. Alternatively, they could look for an overseas partner in commercialisation -- outside commercialisation. They could license the

innovation, seek buyers for their research firm or enter into a strategic alliance. This path leaves it to others to make the commercialisation investments. In choosing between them these two paths, the inventor appears to face a simple trade-off. Suppose that the costs of the various commercialisation investments, if they are undertaken by the inventor, in-house, are some positive number, K. Suppose that the total expected returns from the innovation is V. Finally, assume that if the inventor enters into partnership they will only earn a fraction α (where 0 < α < 1) of the expected returns. It would appear that in-house rather than outside commericalisation would be advantageous so long as V - K > αV or (1-α)V > K. The conventional wisdom is justified when α is relatively low; that is, the more you have to give away by not commercialising the innovation yourself. As α falls, the above expression is more likely to hold, making in-house commercialisation more advantageous.

α being small means that the Australian inventor expects to capture only a small fraction of
the total returns from innovation when it enters into a cooperative arrangement with others. When the overseas firm is a large manufacturer, it might appear that the Australian inventor would not command a strong bargaining position and hence, be unlikely to capture the returns from innovation by going outside. But this is mere supposition. It is critically important to this argument to

understand where α comes from. And in this, economics provides an important set of principles to guide us. These are based on the notion that outside commercialisation

represents a cooperative arrangement and it will not occur unless it is better than the outside opportunity for both parties. From the point of view of the overseas firm, this means that the following condition must hold:

Melbourne, July 1997; available at http://www.mbs.unimelb.edu.au/home/jgans.

5 Condition 1 (Feasibility): α must be small enough so that the overseas firm receives a return that covers its own commercialisation costs. This places an upper bound on α , limiting inventor returns. If outside commercialisation costs are the same as those that would be incurred by the Australian inventor (i.e., K), then this condition means that (1-α)V must exceed K. This is precisely the same condition that would make the inventor’s optimal choice in-house commercialisation rather than partnership. But this is a maximal value for α for outside commercialisation to be a feasible option. In general, α will be lower than this, making outside commercialisation strictly desirable from the inventor’s point of view. Therefore, whenever finding a partner is a feasible solution -- in that the overseas firm will obtain a minimum return on its investment -- it is also a worthwhile solution. But this does not really compare like with like. For example, the costs of commercialisation might differ between the two parties. The overseas firm might face a commercialisation cost of K which may be higher or lower than K. In this case, feasibility requires that α be low enough so that (1 − α )V > K , while the inventor will choose to make rather than buy commericalisation if (1-α)V > K. What this means is that, assuming outside

commercialisation is feasible, in-house commercialisation will only be desirable if K < K . That is, the Australian inventor must actually be able to commercialise the innovation more cheaply than the overseas firm. What determines whether the Australian inventor has such a commercialisation cost advantage? The key to this lies in thinking about what advantages an inventor might themselves have in commercialising a product. One plausible advantage might come from the use of specialised knowledge in the innovation that is of use in setting up production systems and the like. However, this must be weighed against advantages an overseas firm might have in distribution networks and regulatory approval. Such considerations are of key importance for any biotechnology product, for instance. In this case, one would have to ask what cost advantages might exist for the inventor compared with a situation in which

6 they enter into a contract with the overseas firm to supply the type of specialised production knowledge they might need. When viewed in this light, the case for an overwhelming cost advantage to the Australian inventor looks thin. 4 There is another factor that might differ between in-house versus outside commercialisation. Consider who might be the primary candidates for a commercialisation partnership. In biotechnology, these would be large overseas pharmaceutical companies with already established distribution and regulatory approval networks. They have existing plant and production criteria. In the computer industry, there are several incumbents with key brand name images that offer them a marketing advantage. By entering into a

partnership or licensing agreement with such firms, the Australian inventor accesses those advantages, thus, yielding a overall return of V . The critical point here, however, is that the overall returns from innovation are higher when engaging in a partnership than by in-house commercialisation. This latter path is a path of competition with incumbents in the industry. In most situations, the invention itself is not so drastic as to totally reshape an existing industry. Incumbent assets are still of value. Hence, in-house commercialisation, even when this has cost advantages, is a path towards direct competition with incumbents. And this means a dissipation of profits in the industry. While this benefits consumers, it harms all firms in the industry. There are, therefore, considerable advantages to a contracting or cooperative solution as opposed to a competitive one.5 V is likely to be much greater than V. This biases the trade-off in favour of outside commercialisation. But notice that such a possibility raises the return an Australian inventor can hope to receive. To consider this, suppose that competition for the Australian inventor was worthwhile with V above K.

H.W. Chesbrough and D.J. Teece, “When is the Virtual Virtuous?” Harvard Business Review, Jan-Feb., 1996, pp.65-73; discuss the conditions under which it is best to integrate innovation with commercialisation. 5 The formal economic analysis of this issue is contained in J.S. Gans and S. Stern, “Incumbency and R&D Incentives: Licensing the Gale of Creative Destruction,” Working Paper, No.17, Melbourne Business School, 1997.

4

7 Suppose also that entering into a cooperative arrangement with the overseas firm was very rewarding to that firm, with V − V very large. Then the overseas firm would have to convince the Australian inventor not to enter into competition. This following condition would have to hold: Condition 2 (Sufficient Compensation): α has to be high enough so that the Australian inventor earns at least V - K. That is, αV > V − K . The threat of competition would make outside commercialisation a worthwhile option.

Figure One: Choice Between In-House and Outside Commercialisation

Premium of Cooperation over Competition

Outside Commercialisation

In-House Commercialisation
Commercialisation Cost Advantage In-House Commercialisation Cost Advantage Outside

In conclusion, the simple economics of exchange mean that outside rather than inhouse commercialisation is an attractive option for Australian inventors. The range of

situations in which outside rather than in-house commercialisation is attractive are depicted

8 in Figure One. These depict the points at which V − K > V − K , making outside

commercialisation the better option. When this condition holds, the overall returns from innovation are maximised when the Australian inventor enters into an outside partnership. Even when K < K , some of the cost advantages can be realised in a strategic partnership. But more critically, for most inventions direct competition reduces industry profits relative to a cooperative arrangement, hence, making outside commercialisation the likely path towards maximal innovation returns.

Shades of Grey

Conditions 1 and 2 tell us that any division of the innovation pie (i.e., value of α) must be such that both the inventor and overseas firm are better off when the inventor chooses the path of outside commercialisation. As this requires the pie itself to be larger when outside rather than in-house commercialisation is pursued, this leaves a large area of indeterminacy for α. So it is reasonable to ask: what factors will make α relatively high? Broadly speaking, the two most significant determinants are the number of interested potential partners and the overall strength of intellectual property rights. I will deal with each in turn. One important determinant is the strength of competition among alternative overseas firms. For a significant enough invention, there could be several overseas firms that would be suitable partners. This means that if the Australian innovator negotiates with any single one it has a strong outside option -- it could go to any of the others. This allows the inventor to play one off against the other and drive α as high as possible (given Condition 1). But notice that in this environment, product market competition is likely to be more intense. Therefore, it is entirely possible that V − V might be relatively low as even a cooperative arrangement could be relatively competitive.

9 Another important determinant is the strength of actual property rights. This can take several forms. First, when the inventor has a patent on the invention (such as for many biotechnology products), this prevents others from copying the idea. This makes V − V relatively high as imitation is not possible. It also protects the inventor during negotiations from problems of disclosure. However, even with a patent, and especially without one, property rights are weaker (as in computer software). This reduces the bargaining position of the inventor. Overseas firms might have their own in-house research and development processes and hence, may not value the Australian invention very much. This is because they could easily replicate another invention of similar economic value. This not only reduces the value of the Australian invention but also the profits from in-house commercialisation. That is, if the Australian inventor chooses to compete directly with the overseas firm, they will soon face competition from overseas innovations. Both of these effects reduce the level of α . Note, however, this does not mean that outside commercialisation is unattractive. Indeed, it might be more attractive given the greater toughness of product market competition. It does mean, however, that the maximal returns from innovation an Australian inventor might hope to appropriate would be relatively low.6 In summary, gaining a patent and securing the interest of a number of overseas firms might raise the share of the pie accruing to the Australian inventor. However, these factors might also be less attractive when intellectual property rights are not as strong. In this case, the Australian firm might face competition in both the innovation and product market, lowering their overall incentive to engage in inventive activity.

6

In J.S. Gans, “Driving the Hard Bargain for Australian R&D,” Prometheus, March 1998 (forthcoming); I discuss the implications of this for Australia and demonstrate that this effect could account for Australia’s relatively poor performance in research and development.

10

Policy Implications

In many ways, the above analysis paints a bleak picture for Australian research and development. I have argued that maximal returns will be yielded when Australian inventors choose a path of outside commercialisation. However, these returns might not be high given the nature of the intellectual property and competitive environment. In primary high technology areas such as computer software and biotechnology, Australian inventors face considerable technological and product market competition. This limits the potential for them to appropriate a large share of the returns from innovation. My analysis, however, suggests that government policies that direct scarce funds towards projects which are directed at in-house commercialisation makes this situation worse. Our public money is going towards ends that do not guarantee the highest possible returns from research and development. Moreover, funds with conditions of in-house commercialisation make matters even more difficult by restricting the options Australian inventors have in commercialising innovations. Nonetheless, there are two important directions that could redress this misallocation of public resources. First, by subsidising innovation directly rather than attempting to generate Australian-based commercialisation, the government can provide a direct incentive for innovation. Indeed, a positive criteria for this funding is the potential existence of favourable outside commercialisation possibilities. These opportunities should be extolled rather than decried. Second, by providing incentives for in-house commercialisation, local venture capital and the like, the government can enhance the bargaining position of Australian inventors. Recall that α will be relatively high when the profits from in-house Thus, by providing funds for this end, the negotiating

commercialisation are larger.

position of Australian inventors is improved.

11 The focus of research and development policy should be on ideas, their incentives and hence, their returns and not on the production of objects. There is no shame in

becoming an economy that specialises in idea production. The key policy direction should be towards making our research and development processes more productive and ensuring that government aid maximises the potential returns from commercialisation rather than stifling them.

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