Hold on for increasing returns... In the last Sunday article on a theory of innovation, I observed that innovation is a very wasteful process.  It includes a lot of trial and error, mostly error.  So, if you need to be efficient, you cut back on innovation.  Necessity is the mother of efficiency, and the enemy of innovation.

So, one of the prerequisites of innovation is abundance: subsidies; risk capital;  extravagance;  youth;  total war, whimsy; bubbles; money to burn; free food.  One of the things that I noticed when visiting Silicon Valley during the last few years was free food at most of the events and offices that I went to.   Last week I did a tour of Kendall Square, Cambridge, at which I was offered free food at every stop, so maybe the East Coast is on the way back.  Don't starve your innovators.

Abundance doesn’t need to come in the form of money.  The software industry is currently floating on a tide of code delivered by the Internet.

However, if abundance was the only requirement for innovation, then the emperor or superpower of the day could just order up some innovation.  That’s clearly not what happens.  Great powers don’t necessarily stay ahead of the curve.

The curve looks like this:

History implies that both evolution and innovation have a punctuated dynamic.  They can be stagnant for a long time, and then suddenly take off in an exponential curve.  One striking example of this is the evolution of human technology.  It’s easy to imagine that the top-level production curve that counts the number of different devices used by humans worldwide was pretty flat for tens of  thousands of years, was on  a slow exponential increase through the middle ages, and hocky-sticked about 200 years  ago.   We have better data for specific industries, for example, we could count the number of different silicon chips after 1950, and we would see exponential curves.

This is a picture of increasing returns.  Innovation leads to increasing innovation.  Invention is the mother of invention.

Why does innovation tend to accelerate from an initial spark?  There is no established research or theory about this.  However, I can list four factors that I think accelerate innovation.

An abundance effect:  Successful innovations generate resources that can be burned up in the quest for more innovation.

A network effect:  The more things that you have, the more ways you can combine them.  If you start inventing machines that produce new materials, you can combine the results into even more new types of machines.  It’s clear that this effect is strong in industrial economies, and in software production, and it is used extensively by bacteria, which swap DNA.

A platform effect:  Innovation builds on previous innovation.  Its primary quality is that it produces a very durable good (which I called design) that lasts forever, builds up in layers, and can be reused an indefinite number of times.  This can create a new platform for further innovation.  This is a supply-side effect.  If you invent multi-cellular life, you can supply a Cambrian explosion in species diversity.   If  you invent silicon chips, you can make a lot of new stuff.

Evolutionary space:  When creatures moved from sea to land, they found a lot of empty space.  There was room for a lot of new species.  When users start reading the Internet, they create a lot of empty space for  new media.  This is a close relative of the platform effect, but on the demand side instead of the supply side.

In this list we have two factors with increasing returns.  The network effect gets stronger as the network gets bigger, and the abundance effect gets stronger as you invent more things that deliver abundance.  So, that can explain increasing return to innovation.  We also have two factors with decreasing returns.  A platform has limited width.  Eventually you use up the new space on top of a big innovation.  And, you also use up evolutionary space.  So, it’s not surprising that industrial innovation has a decreasing returns phase.  If you look at the number of different products in an industry over a longer period of time, you get a leveling off, the famous S-curve.   Eventually, there is a decline.

So far, we have only seen the exponential phase of our great experiment in human industrial production.  Will this continue to accelerate, producing more amazing things, and more abundance?  If it is not bounded, it will eventually go vertical, and we will burst through to a new future in a great rush.  This is the hypothesis popularized by Ray Kurzweill. We might find a great arc of technology moving from the slow evolution of DNA, to our current use of silicon, to an evolutionary technology that constantly accelerates itself.  This is implied by my claim that there is a theory and a technology that can accelerate innovation.

However, I don’t see this as a foregone conclusion.  Subjectively, it seems that we have reached a phase where industrial innovation is decelerating.  The difference in my grandmother’s lifestyle between 1900 and 1955 was enormous.  The difference in lifestyle between 1955 and 2010 is much smaller – some new gadgets, and a small increase in the effectiveness of medical treatments.  Pretty much all economic growth in that period can be traced back to one “platform” – the increased use of oil and electric energy.  This continues today.  Chinese economic growth can be mostly linked to their rapidly increasing use of energy, not innovation.

I recently saw an economist who noted that the American economy (which is not using increasing amounts of energy) and stock market have stagnated in the last ten years because we didn’t get a big lift from new innovations.  On the other side, Louis  C.K. tells us about stuff that really is amazing... but planes were invented 100 years ago.

So, where should we invest to get lift?  I hypothesize that you want to invest where you see increasing returns.  The competition will be more intense than in decreasing return industries, because of the “non-rivalry” attribute that  allows anyone to use new design.  However, the lift from increasing returns is powerful enough to counter that. 

One obvious case is in biotechnology.  Most biotechnology investment goes into developing drugs.  However, the productivity of this investment has been declining rapidly.   Increasing amounts of money and ever-more ingenious new science and technology produce fewer and fewer new drugs.  They tend to produce new drugs that aren’t as good as the old ones.  So, we can see that this effort has diminishing returns because of space.  The “drug targets” in a human body have been used up.

On the other hand, you could use biotechnology to produce new materials and new organisms.  This is the approach taken by companies making new types of biofuels.  I would expect this effort to lead in an increasing number of directions, and benefit from increasing returns.

So why aren’t more biotech companies investing in new materials and organisms?  Because it’s risky, and wasteful, and they have no idea where it will go.  It requires real innovation.