Innovation Theories: Relevance and Implications for Developing Countries

Andranne Lger1, Sushmita Swaminathan2

Abstract
Innovation is at the basis of economic development and as such, it is instrumental for developing countries.
However, the process of innovation is still a challenging subject of research in economics, and most efforts have
concentrated on understanding the process in industrialised countries, even though empirical evidence shows
that the innovation process could follow a different pattern in developing countries. We review the literature on
innovation from the perspectives of the different branches of economics to identify areas of further research and,
more importantly, build a holistic conceptual framework including these various contributions and identifying
areas for further research in this area.

1. Introduction
Innovation is at the basis of economic development and as such, it is instrumental for developing countries (LDCs). However, the process of innovation is still a challenging subject of research in economics, and most efforts have concentrated on the understanding of the process in industrialised countries
rather than in developing countries.
In this paper, we review the literature on innovation from the perspectives of the different branches of
economics to identify areas of further research and, more importantly, build a holistic conceptual
framework including these various contributions. Empirical evidence shows that the innovation process
could follow a different pattern in developing countries. We hence modify our conceptual framework
to better represent the case of developing countries, and set the bases for future work in this area.
The paper is structured as follows. In the next section we present a basic model of innovation, followed
in section 3 by a review of the different branches of the economic literature. In section 4 we present and
1

Dept. International Economics, German Institute for Economic Research (DIW Berlin), and Chair for International Trade and Development, Humboldt University, Berlin.
2
Dept. Information Society and Competition, German Institute for Economic Research (DIW Berlin), and Chair for Economics and Business, Humboldt University, Berlin.

discuss our conceptual framework, and in section 5, we describe developing countries and modify our
conceptual framework to better represent their characteristics. In section 6 we discuss the implications
and conclude in section 7.

2. Innovation: Background
Innovation can be defined as all the scientific, technological, organizational, financial, and commercial
activities necessary to create, implement, and market new or improved products or processes (OECD,
1997). For the purpose of our work, we focus on the firm-level innovation process and concentrate on
the scientific and technological activities supporting the performance of innovation.
To do so, we use a well-known model of innovation3, the chain-linked innovation model (Kline and
Rosenberg 1986) representing the technical activities occurring in the innovation process, the external
forces of the market place, as well as the complex interactions between the various stages of the process (see figure 1).
Figure 1. Chain-linked Innovation Model
Research
3

K
D
1

Potential
market

Knowledge

K
2

C
Invent/
produce
analytic
design

K
2

C
Detailed
design
and test

C
Redesign
and
produce

C
Distribute
and
market

f
f
F

Source: Kline and Rosenberg, 1986.

3 For an overview of previous innovation models and more details on the chain-linked model, see also Kline, 1985.

Uncertainty is a key concept: in fact, innovation is defined as an exercise in the management and reduction of uncertainty (Kline and Rosenberg 1986). It relates to two aspects: the technical performance of the innovation, but also the market response to its introduction. The model identifies five major
paths of innovation processes: the central chain of innovation (C) starts with the invention/ production
of a design, based on market signals, that is then developed, produced and marketed. The process includes feedback loops (F, f) iterating the steps and controlling for perceived market signals and users
needs, and linkages between science and innovation (K), representing the recourse to various knowledge stocks accompanying the whole process. The two other linkages represent the (rare) case where
new science makes possible a radical innovation4 (D), and finally the feedback from innovation results
back to science (S).
In the model, market-pull and technology push aspects of innovation are interdependent. Perceived
demand will be met only if the appropriate knowledge and technology are available, and an innovation
will be realised only if there is a market for it. An important aspect that is not explicitly addressed by
the model is the appropriability of returns from innovation, related to the nature of information. The
result of innovation is not only a new product or process but also the creation of new information,
which has public good characteristics. The use of it by more than one person does not require additional resources (non-rivalry) and does not exclude the use of it by another person (non-excludability).
These two properties of information make the gains from innovation uncertain and difficult to appropriate, which implies that R&D opportunities that would be socially profitable are not exploited because they are privately unprofitable. Such a market failure is said to exist when private incentives provided by market mechanisms lead to a different resource allocation and a different product mix than the
socially optimal outcome (Alston and Pardey, 1999). In order for innovation to be undertaken, incen-

4 This model considers that the link between science and innovation is not preponderantly at the beginning of typical innovations: confronted with a problem, scientists first call on known science and stored knowledge, and only when this mechanism fails to solve the
problem will specific R&D activities be considered (Kline and Rosenberg, p. 291).

tives need to be given. IPR is suggested as one possible government intervention to correct for this
market failure5.
With IPR arises the dilemma of access versus appropriability (Alston, Norton and Pardey, 1995). By
granting temporary exclusive rights on inventions, IPR are intended to allow the right-holders to price
their products above marginal cost, and hence recoup their initial research investment. Such exclusive
right creates incentives for the performance of R&D leading to innovation. However, monopolies that
are not regulated can create inefficiencies: too little of the good is produced, and its price is too high.
IPR hence create a trade-off between dynamic gains, due to the improved innovation incentives, coupled with static losses due to the restricted use of the innovation (Moschini, 2004).
Natural appropriability mechanisms, such as for example secrecy, lead time and learning curve advantages, also exist. The principle is the same: to secure a monopoly position for the innovation in order to capture the returns from innovation, but the emphasis is put more on retarding or impeding imitation by other firms6.
Finally, innovation by chance is not covered by the model, even though it was at the origin of several
important innovations (e.g. penicillin). Modelling a stochastic process is difficult, but this important
source of innovation also needs to be mentioned.

3. Economic Theories: Different Perspectives

This section reviews the different branches of the economic literature on innovation to identify areas
where further research is needed, and improve on the chain-linked model of innovation.
3.1. Industrial Economics
In the standard analysis of a perfectly competitive equilibrium, concepts of non-convexity, externalities, public goods, and uncertainty are not accounted for. It is these same concepts that are required to

5 Other interventions can include tax breaks on the performance of R&D, contests, or public performance of R&D.
6 The relative effectiveness of these methods will be discussed in section 3.3.

understand innovation within different market structures. Empirical research reveals that an intermediate market structure, one that is neither perfectly competitive nor perfectly monopolistic, is usually
most conducive to technical advance (Kamien and Schwartz, pp. 3, 1982).
Adam Smith in his Wealth of Nations (1937) identifies innovation as requiring the investment of
money and as an important economic activity inducing gains. It was however Schumpeter who more
formally explained the role of economic agents in technical advance. He differentiates between the
inventor and the entrepreneur. The latter is defined as one who sees how to fulfil currently unsatisfied
needs or perceives a more efficient means of doing what is already being done and receives extraordinary profits as a result (Kamien and Schwartz, 1982). Economic development is referred to by Schumpeter as creative destruction whereby monopolies are formed albeit temporarily due to the catching
up of newcomers. In the perfectly competitive market, these profits would be immediately reduced to
normal levels due to imitation. Hence Schumpeter (1942) concludes that perfect competition cannot
exist along with entrepreneurship.
Schumpeter (1942) believed that larger firms have a critical advantage with respect to innovation. This
theory was further refined by Galbraith (1952). The main aim of firms is to maximise expected profits.
R&D is a risky and costly undertaking; Hence an industrial organization of large monopolistic firms
offers decisive welfare advantages and larger firms are able to achieve scale economies, diversify, develop market reputation, etc. as shown by empirical studies (Scherer 1965, Cohen and Klepper 1996).
Nelson (1959) contends that the more widespread the reputation and name of a firm, the higher the
chances of full exploitation of its research efforts. Based on his empirical analysis, Schmookler (1972)
claimed that after a certain large size, the efficiency of inventive activity varies inversely with firm
size. Williamson (1965) further explains the factors which hinder innovation in a large firm. Another
possible reason for the lack of innovation by large firms could be the scarcity of ideas concept
(Scotchmer 2005, Varian 2004). Ideas develop from the existing technological base and scarcity means

that only one inventor caters to the market with his or her idea. Disclosure of the ideas increases the
chances that the subsequent idea would come from a rival.
Innovation is supposed to be highly competitive and small firms are in a better position to fully exploit
it, combined with their focus on new innovative technologies (Hicks and Buchanan, 2003), and take
over from the incumbent (Malerba, Orsenigo, and Peretto 1997). Small firms have been shown to be
more efficient in the use of capital and labour resources (Acs and Audretsch 1991). Both large and
small firms exhibit advantages and disadvantages, the right size could depend on the type of industry.
An innovation study carried out in some Latin American firms (Arocena and Sutz, 2000) finds that
little is invested in innovative activity. In India, a study on small- and medium-sized firms finds that
vertical integration, export orientation and competitive pressures heightens the need for spending on
R&D (Kumar and Saqib, 1996).
Schumpeter speaks about the innovation process but does not specifically explain how innovations
come about nor does he consider whether there could be overinvestment or too much destruction. A
counter explanation is given by Arrow (1962), which presents an investigation in the allocation of resources for innovation. Innovative competition creates higher levels of uncertainty as competition can
come from any industry. He was the first to distinguish that invention is different to risk-bearing. In
doing so he highlights a principle and agent problem. Invention is carried out by the agent and he may
or may not chose to bear any risk. If he chooses not to, he just accepts the fee for his service and the
principle i.e., the investors then bear most of or all the risk. According to Arrow, this imbalance or inability to shift risks without proper monitoring results in moral hazard and hence underinvestment in
risky activities. Given the characteristics of knowledge incomplete appropriability, its use subject to
indivisibilities and its marginal cost close to zero, a free enterprise economy is expected to under invest
in invention and research (as compared to the social optimal). This underinvestment will be greater for
more basic research.

There are two solutions to this problem; turning to the free forces of the market, or government intervention, particularly in financing basic research. If abiding by the free market i.e., large firms undertake
innovation, it should be noted that Arrow (1962), Usher (1964), and Schumpeter himself recognize that
monopoly power tends to retard innovative growth. The complacence in the position reduces the incentive to innovate in comparison to a new comer for whom the prospect of monopoly profits is a much
greater incentive. This leads Arrow (1962) and Hellwig and Irmen (2001) to conclude that the incentive
to innovate is greater in the perfectly competitive market.
Government intervention can be utilized in the case where an inventor is unsatisfied with the incentives
given to invest in R&D, and hence refrains from inventing, though society may benefit from it (Mansfield et al., 1977, Terleckyji, 1977). A long-term contract must guarantee the parties a fair return in
order to encourage specific investment (Tirole, 1993). Conversely, with IPR overinvestment and duplication could also take place due to increased perceived benefits or the race for monopoly power. However, government innovative undertakings have not been particularly successful and few western governments are involved in the actual development and marketing of innovations (Kamien and Schwartz,
1982). This was refuted by Scotchmer (2004) who claims that a substantial amount of the innovation
taking place (American example) is the result of government development and mixed innovative efforts
from both the public and private sectors of the economy.
Empirically, the impact of the diffusion of information is supposed to have had a substantial impact on
innovation (Brynjolfsson and Hitt, 2003), particularly in the area of information technologies. From a
cumulative innovation perspective (Hall 2004; Bessen and Maskin, 2000), temporary market power and
the associated reduction in diffusion could block subsequent innovation. A related issue refers to spillovers whereby firms experience inter-industry learning. Often innovations come from different industries and provide further learning opportunities and responses to unfulfilled demand. The intuition behind it claims that as an industry becomes more competitive, the private loss associated with the public
good character of R&D spillovers diminishes relative to the private benefit of being able to exploit
7

competitors spillovers (Cohen and Levinthal 1989). Competition tends to be most intense when firms
are on the same level (Tirole, 1993). Imitation is a possible firm strategy when development costs are
high. Comanor (1967) and Shrieves (1978) indicate in their empirical findings that resources are allocated towards those innovative activities which are not easily imitable. In LDC with the ability to assimilate, imitation maybe more a preferred strategy as it enables learning through imitation and reverse
engineering (Lall, 2003).
Industrial economics highlights two important determinants of innovation: market structure and firm
size. Empirically there are three views with regard to market structure and innovation; Positive and
negative correlations between monopoly power and innovation (Scherer 1967, Levin, Cohen and
Mowery 1987, Nickell et al. 1997). Perfection competition is the more suitable market structure to create incentives for innovation (Hellwig and Irmen 2001, Boldrin and Levine, 2003). Finally that innovation, particularly sequential innovation occurs best in a monopolistic competitive structure due to the
customers love for variety (Dixit and Stiglitz 1977). Ideas and competition occur across markets affecting the traditional incentive structures and the amount of learning that takes place. There is learning
within a firm based on R&D activity, past experience, lead time reputation etc., and learning within an
industry. The latter is limited to firms that are similar in size and development (Tirole, 1993). Thus
though the impact and type of market structure and firm size is still inconclusive, it is an important determinant of innovation and future technical advance. Innovation can thus be viewed as a result of firm
size, the industry it belongs to, market demand and structure and the associated spillovers and diffusion
that takes place.
3.2. Institutional Economics
Externalities are an important characteristic of innovation. Property rights are defined to internalise
externalities, and, in the case of IPR, they ensure that the benefits from an invention are concentrated
with the innovator, which provides more incentives for further innovation (Demsetz 1967). However,
8

with any property rights structure transaction costs are positive, which implies that rights are never perfectly specified and enforced (North 1990), hence affecting the appropriability of returns.
Furthermore, as Coase (Coase 1937; Coase 1960) put forward, when transactions are costly, institutions
matter. Societies develop informal institutions, such as culture and norms (Williamson, 2000), as well
as formal institutions, to reduce the importance of transaction costs. Formal institutions relevant to innovation are IPR and the associated legal organizations needed for their enforcement, i.e., the legal
system, which are part of the institutional environment. IPR play an important role, since they solve
what Arrow called the paradox of disclosure (Arrow 1962). Information that is not afforded legal protection cannot be traded on the market, since in order to sell the information, the inventor must disclose
it but then has nothing left to sell. The defining role of IPR is hence especially important in hightechnology industries, where collaboration in R&D is vital.
The environment in which these rights exist is decisive: On the one hand, it determines the quality of
the rights (the enforcement) and hence the extent to which they reduce transaction costs and correct for
the public-good market failure. On the other hand, in a world of incomplete contracts and transaction
costs, (Pagano and Rossi 2004) describe the existence of self-reinforcing interactions between property
rights and technology, leading either to virtuous complementarities or to the perpetuation of inequalities. Agents (or countries) tend to acquire abilities because they have IPR and tend to acquire IPR because they have abilities while some agents may be trapped in an equilibrium where they do not acquire IPR because they do not have specific abilities, and they do not acquire these abilities because
they do not have IPR.
Transaction costs have been found to play an important role with respect to innovation. In the Mexican
maize breeding industry (Lger 2005), information, certification and enforcement costs were high
enough to hamper the incentive effect of IPR, and similar conclusions were reached for a panel of
Japanese firms after the strengthening of IP protection in that country (Branstetter and Sakakibara
2001).
9

Informal and formal institutions also influence the innovation process. Looking at R&D investments,
(Varsakelis 2001) found national culture to be a determinant of R&D intensity, using a panel of developing and industrialised countries. Comparing countries with similar culture and norms, (Waguespack,
Birnir et al. 2005) found the stability of political institutions, hence the institutional environment, to be
an important factor explaining the propensity to patent. Furthermore, private agricultural R&D investments in OECD countries would also respond to the quality of the institutional environment, i.e., efficient bureaucracy, enforcement of contracts and IP protection (Alfranca and Huffman 2003).
The direct link between IP protection and innovation is empirically more fragile. In OECD countries
(Furman, Porter et al. 2002; Alfranca and Huffman 2003), IPR would play an important role in supporting innovation. Most studies using cross-section or panel data of developing and industrialised countries also find similar results (Varsakelis 2001; Kanwar and Evenson 2003; Lederman and Maloney
2003). However, different results obtain when looking at LDCs. Expanding the Furman, Porter and
Stern (2002) framework and applying it to five East Asian countries, (Hu and Mathews 2005) do not
find IPR to be a significant factor explaining innovation (patent applications). Similarly, comparing the
determinants of innovation for LDCs and industrialised countries shows that, while IPR have a positive
and significant impact on innovation in the latter, the effect is negative or non-significant for the former
(Higino Schneider 2005).
Overall, from the theory, transaction costs are expected to negatively affect the incentive effect of IPR,
which is supported by the empirical evidence available. Similarly, it is essential to take formal and informal institutions into account in studying innovation. The role of one such institution, IPR, is however not clear theoretically, and the empirical evidence is mixed, especially for LDCs.

10

3.3. Evolutionary Economics

Evolutionary economics represents a departure from neoclassical theories and assumptions7. It attempts
to explain the innovation process by reconciling the related micro- (firm-level) and macro-evidence. It
is based on the Schumpeterian vision of the economic world as a succession of disequilibria, explicitly
dynamic and evolutionary, however seeing invention as an endogenous process rather than as an exogenous force acting on the economic system. As such, the environment in which the firm operates
must also be taken into account, which is especially considered in the literature on systems of innovation (Lundvall 1992; Edquist 1997). While most of the evolutionary economists use simulations to test
their models, this branch of the evolutionary literature provides empirical evidence on some of the issues discussed in this section.
In evolutionary economics, the concept of diversity, relating to the different firms characteristics and
decisions and differences in the environment in which the firm evolves, is key to the explanation of
inter-industry and inter-country differences. Taking into account the innovation system as a whole allows explaining a significant portion of inter-country differences in innovative performance (see the
studies in Nelson, 1993 and Kim and Nelson, 2000, and (Freeman 2002; Furman, Porter et al. 2002; Hu
and Mathews 2005), which pleads for the inclusion of such factors in the analysis of innovation.
Continuity is another important concept and relates to the dependence of current performance on earlier
decisions and actions (path dependence). Several examples of this phenomenon have been reported, the
most famous being probably the QWERTY keyboard case (David 1985), but other studies using historical data, for example on coal wagons in Britain (Scott, 2001) confirmed the relevance of this concept.
In the day-to-day activities, such continuity is expressed through the development of routines that reduce learning and other transaction costs. They however cause resistance to change, and hence can

Among others, bounded rationality, with incomplete information and no foresight, where actors are not independent and
not optimizing their utility but rather adopting a satisficing behaviour. See Nelson and Winter, 1982.
11

slow innovation or adoption in the medium- and long-run (Nelson and Winter 2002). Through the execution of routines and other day-to-day activities, a learning process takes place: learning-by-doing and
learning-by-using contribute to the development of tacit knowledge, that is difficult to transmit and
often embodied in the firm or individuals. This knowledge is also instrumental for the absorption and
use of inter-firm spillovers (Ruttan, 2001). This is then contrasted with information that can be codified
and transferred (Dosi 1988). We define these as knowledge and information, respectively, and will use
these terms in the remaining sections.
Based on this distinction, one can also distinguish between two types of innovations: the cumulative
innovation motivated by the need for improvements that has been identified through routinized activities, and the discrete, independent development that often indicates the beginning of a new technological paradigm (Dosi and Nelson 1994; Klevorick, Levin et al. 1995). Knowledge and information are
inputs in the occurrence of both types of innovations, to different extents. The main point is that from
these differences arises the need for different policies, for example, IPR would be beneficial to society
for independent innovations, while they would inhibit technological progress when used to protect cumulative innovations.
Results from the Yale Survey (Levin, Klevorick et al. 1987; Klevorick, Levin et al. 1995) show that
spillovers discourage R&D in industries with independent, discrete innovations such as chemicals and
pharmaceuticals. This is confirmed by the results obtained in other studies (Mansfield 1994; Mansfield
1995), which find these two industries to be among the few where patents provide incentives for innovation. On the other hand, in industries characterised by cumulative innovation (e.g. electronics, software industries), spillovers of rival firms might raise the productivity of the firms own R&D and IPR
would inhibit technological progress (Levin 1988; Klevorick, Levin et al. 1995). Another survey
(Cohen, Nelson et al. 2000) finds that the propensity to patent has increased over time, which could
hence create even more important barriers to innovation in cumulative industries.

12

The basic assumptions of evolutionary economics appear to reflect more adequately the processes and
environment characterising innovation. The stickiness of knowledge, and the costs related to its transfer
are theoretically better represented when distinguishing between knowledge and information and taking
them as related, but distinct items. Appropriability of returns to innovation, through IPR or normal appropriation mechanisms, explains a significant proportion of inter-industry differences in innovation,
and the evidence shows that patents are not always so important as long as other mechanisms exist.
Finally, the importance of national institutions and characteristics is again supported by the case studies
in the area of systems of innovation, where country characteristics explain a significant proportion of
inter-country differences in innovation.
3.4. International Trade
Given the growing importance of trade liberalization and economic integration, interactions between
trade and innovation received increasing attention in the literature8 (Grossman and Helpman 1990;
Grossman and Helpman 1991; Grossman and Helpman 1994). In most of these models, the principles
of growth theory have been transposed to the two-country case, taking explicitly into account the differences in factor endowments and prices between the trading partners. Therefore the determinants of
innovation are similar to the ones already discussed in previous sections, e.g. endowments and factor
prices, market structure and competition, demand pull factors. However, the problematic of trade as a
cross-country channel of information is emphasized.
On the one hand, intended information transfer takes place, through technology transfer and/or licensing. In such a case, IPR are needed to define and protect the object of the transaction, and serves as a
supplementary source of revenues for the patent-holder. The empirical evidence in this area shows that
IPR do play a role for technology transfer: In the absence of IP protection, American firms were less
likely to licence advanced technologies to unaffiliated firms (Mansfield 1994). Similar results were
8 Most the work on innovation and trade focuses on the inverse relationship, that is, the role of technology as a determinant of trade patterns (e.g. Dornbusch, Fischer and Samuelson, 1977, Krugman, 1979; Wakelin, 1997).

13

obtained for Japan and Germany (Mansfield 1995). Using a panel of developed and developing countries to investigate the impact of patent strength on technology transfer from the USA, (Yang and Maskus 2001) find stronger patent laws to have a positive and significant effect on receipts from licensing
fess and royalties, as do (Branstetter, Fisman et al. 2005), looking more specifically at the case of multinationals and their foreign affiliates.
On the other hand, unintended transfer takes place through spillovers, either from foreign direct investments (FDI) or trade flows. Total factor productivity in industrialised countries is found to be positively affected by foreign R&D, more so for more open countries but less so for G7 countries, the most
innovative ones (Coe and Helpman 1995). (Keller 2001) finds similar results, but underlines the importance of domestic R&D levels. A study concentrating on North-South spillovers (Coe, Helpman et al.
1997) finds that total factor productivity increases with the importance of the foreign R&D capital
stock, the imports of machinery and equipment from industrialised countries, and the level of education
of the labour force. Focusing on trade in high-tech industries for a group of developed and developing
countries, (Connolly 2003) finds similar results. A recent paper (Higino Schneider 2005) differentiates
between developed and developing countries and finds market size and infrastructure to be the most
important determinants of innovation for developing countries, while high-tech imports, human capital
and R&D expenditures would be more important for innovation in developed countries.
Studies on FDI in industrialised countries generally find FDI to positively affect innovation and/or productivity in the host economy. Early evidence in Australia (Caves, 1974) finds a positive effect of employment in foreign-owned firms on average value-added per worker. More recent work offers mixed
evidence on this point: Several studies confirm these findings (Maskus 2000) but evidence showing the
opposite is also important (Higino Schneider, 2005; Connolly, 2003; Lichtenberg and van Pottelsberghe, 1996). Evidence on LDCs alone tends to support the latter results (Higino Schneider, 2005;
Aitken and Harrison, 1999; Hanson, 2001).

14

Finally, certain models assume the existence of a freely accessible global stock of information to which
countries can turn to find appropriate solutions to their problems (Grossman and Helpman, 1991). Conversely, other models assume completely endogenous technological change, implying that a countrys
technological status is related only to its own innovations (Romer, 1990). Eaton and Kortum (1999)
develop a model of endogenous innovation with international diffusion, using patenting abroad from
the 5 research economies (USA, Japan, Germany, UK, and France) as a proxy for diffusion. Their results show that international diffusion of ideas is important: Countries adopt between 50% and 75% of
ideas generated abroad, with the USA deriving most of its growth from its local innovation, and the
USA and Japan generating most of the growth in other countries of the sample. Conversely, using patent citation data for 147 European and North American regions, Peri (2005) finds that only 20% of average knowledge is obtained from foreign regions, and that distance plays an important role. However,
knowledge from technological leaders (the top 20 regions for total R&D) travels further. He also concludes that trade flows are not the only channel of knowledge flows: Indeed, knowledge flows are
much less localized than trade flows. Bottazzi and Peri (2005), using international patents in the USA
and their citations, find that a positive shock to the most innovative country (USA) causes a boom in
innovation in the short-run and sustained productivity growth in the long-run in other countries. In the
long-run, international knowledge significantly contributes to domestic innovation. These three studies
however include only industrialised countries in their analyses, and as was mentioned in the preceding
sections, national characteristics affect the performance of innovation, and are likely to affect the benefits a country can obtain from international technology diffusion.
Overall, intended and unintended technology transfers significantly affect the performance of domestic
innovation, but again, country characteristics have to be taken into account. Especially relevant is the
level of domestic absorptive capacity, and more empirical evidence on experiences in LDCs could help
refine the theory and support the development of more appropriate innovation and industrial policies in
these countries.
15

4. Conceptual framework
Based on the literature reviewed in the previous section, we improve the chain-linked innovation model
to include the contributions from the different economic perspectives and provide a more appropriate
model of innovation. Figure 2 presents this improved model.
The basic model stays the same, but three aspects must also be taken into account:
-

the distinction between knowledge and information. Implicitly, the model assumes that the
innovator has access to more than its own knowledge, however explicitly including intraindustry information implies spillovers among firms, from research (K) as well from the innovation itself (I). Conversely, this implies the presence of other firms in the industry. Furthermore, the feedback loops between the different steps also show that learning takes place in the
firm, hence generating what evolutionary economists call firm-specific, or tacit, knowledge.

the environment in which the firm exists. The structure of the market in which the firm operates affects the performance of innovation, and the policy and institutional environments also
play important roles. The presence of other firms also implies the possibility of imitation, hence
ideally, appropriation mechanisms would also be represented.

the characteristics of the firm. The size of the firm, its resources, and its absorptive capacity
determine the extent to which it can diversify its investments, invest in R&D, and absorb and
process foreign information to respond to market signals. This is difficult to represent, but these
features need to be considered as well.

In fact, such a model can be compared to the ones proposed in the literature on systems of innovation.
However, this literature concentrates on the dynamics of the economy as a whole, where innovation
plays an important role. Conversely, the innovation process is the focus of our analysis, but must be
studied in its environment. As such, and since we do not focus on the different relationships among the
institutions of the system, our approach could be better described as a model of innovation taking
16

into account the national environment in which it takes place, hence looking more at the ecology of
innovation.
Figure 2. Improved Innovation Model
- Market structure - Institutional Environment - Policy Environment
Research
S
D
Information

Industry
Information

Firm-specific
Knowledge

I
Appropriation
mechanisms

Potential
market

C
Invent/
produce
analytic
design

C
Detailed
design
and test

C
Redesign
and
produce

C
Distribute
and
market

f
f
F

Note: The search and research process providing information spillovers (K) exists for the test and redesign steps as well.

International trade is justified by differences between countries: in comparative advantages, endowments, technology and other characteristics, which are taken into account in North-South models of
trade. However, markets and interactions in developing countries are assumed identical to those of industrialised countries or at least these aspects are not especially addressed. The following section
investigates these potential differences further.

17

5. Developing countries
Though varying in their stage of development, LDCs have several characteristics in common when
considering innovation. Mashelkar (2005) classifies countries according to their individual innovative
capability i.e., science and technology base, and economic strength.
Table 1. Classification of Developing Countries
Innovative Capability
Economic High
Strength
Low

Low
II

High
I

III

IV

Source: Mashelkar, 2005

In quadrant 1, countries have substantial economic strength and innovative capabilities. Most industrialised countries fall into this quadrant. Quadrant II includes those countries that have limited innovative
capacity but are economically sound (e.g., Middle-Eastern countries). The third quadrant comprises of
low income countries with limited innovative capacity and economic development (least-developed
countries). For the purpose of our analysis, we focus on the innovative capabilities and hence group
these two quadrants together. In quadrant IV are those countries that, despite their lack of economic
strength, show advances in their science and technological base (e.g., Southeast Asia, India, Brazil,
China, Mexico). This categorization is useful in showing why directly transposing existing innovation
theories to LDCs might not yield the desired results.
Despite these differences, a certain consensus exists on the main features of the economic environment
in LDCs. The market-pull effect is limited in LDCs, given the small purchasing power of the inhabitants. The institutional environment is characterized by the presence of high transaction costs, which
often include corruption (Collier, 1998), and by weak institutions. These affect the functioning of the
market and the transmission of the signals e.g. demand for certain goods to the innovators. Information failures are also predominant, that hinder the discovery of the economic cost structure of new

18

processes and products, hence slowing down adoption. Similarly, coordination failures exist, where the
simultaneous, large-scale investments needed for projects to be profitable (or feasible) do not take
place (Rodrik, 2004).
Markets are often incomplete, weak or non-existent (Lall, 1995), which, for certain areas such as risk,
financial and human capital and information, has important implications for the performance of innovative activities. The standard of education and innovative ability varies among countries, thus making
some countries not only more capable of innovating but also facilitating absorption via technology
spillovers and transfers (Aubert, 2005). Weak structures of education have been found to prohibit technological development, thus implying that human capital is a required input not only to absorb information but to further use this information towards technical advance (Bell and Albu 1999).
In most LDCs, the agricultural sector represents an important share of the economy, and the small industrial sector is not able to employ the growing numbers of high-skilled workers. This leads to a
brain drain through which qualified workers and talented entrepreneurs leave their country of origin
whereby the economic welfare of those left behind decreases (Grubel and Scott, 1966; Easterly and
Levine 2001; Docquier et al. 2003). Though this concept is largely theoretical, Carrington and Detragiache (1998) found that the highly educated from LDCs do migrate to developed countries, that is, to
areas already abundant in human capital.
Government intervention, under the form of the creation of new institutions, is generally appropriate to
correct for market failures such as missing markets. However, in the case of LDCs the institutions are
often less efficient than in industrialized countries, which implies that the market failures cannot be
corrected to the same extent (Stiglitz, 1989).
Given their relatively lower innovative capacities, LDCs are generally dependent on industrialised
countries for the provision of new technology and knowledge. However, they are often rich in traditional knowledge (Aubert 2005). Traditional knowledge is defined as a traditional technical know-how,
or ecological, scientific or medical knowledge, encompassing the content or substance of traditional
19

know-how, innovations, information, practices, skills and learning of systems such as traditional agricultural, environmental or medicinal knowledge (WIPO, 2005).
These characteristics justify the need to modify the model presented in the previous section to better
represent the reality of LDCs (see figure 3). With respect to information and knowledge, the firm has
little firm-specific knowledge to turn to for innovation. Similarly, the industry information is lower
than in the original model, but the firm also has access to traditional knowledge. Finally, the search
process is hampered when it comes to taking advantage of the information available since the firm often does not have the absorptive capacity (R&D base, tacit knowledge) needed to assimilate and apply
it.
Innovations contribute to the stock of industry information, but often to a lower extent to the international pool, given the more local nature of innovation. Similarly, the research taking place in the
search process contributes mainly to the industry. However, given the characteristics of firms and their
generally low level of absorptive capacity, intra-industry spillovers have a lower impact on a firms
innovative potential.
Finally, the market forces implicit in the chain-linked model have a more limited impact in the model
for LDCs. While the previous aspects addressed were mainly relevant for countries at low levels of
development, these are also relevant for more advanced, emerging economies (e.g. Brazil, India, China,
Mexico). First, the size of the market for domestic innovation is often smaller, which provides less incentives for the performance of this activity. On the other hand, the feedback mechanisms from the
market are not as effective given the institutional environment (i.e., high transaction costs, corruption,
weak markets) prevailing in these countries. Finally, international and regional commitments (e.g.
WTO or regional trade agreement memberships, World Bank/ IMF loans and associated obligations)
oblige governments to follow priorities that are often not determined at the national level, and not directed at supporting innovation. This is what Hoekman (2004) calls a reduction in policy space.

20

Figure 3. Chain-Linked Model of Innovation in Developing Countries

Market structure

Institutional Environment

Policy Environment Norms and Culture

Research
S
D
Information

K
Industry
Information/ TK

Firm-specific
Knowledge

Potential
market

C
Invent/
produce
analytic
design

C
Detailed
design
and test

Appropriation
mechanisms

C
Redesign
and
produce

C
Distribute
and
market

f
f
F

Note : The search and research process providing information spillovers (K) exists for the test and redesign steps as well.
Arrows in grey represent the malfunctioning links.

This model also sheds light on other implicit assumptions (or omissions) of the chain-linked model.
The quality and availability of inputs for the innovation process are not discussed, while their absence
or low quality are often important obstacles. Incomplete markets for risk, financial and human capital
can often impede innovation, but these are assumed to be abundant in industrialised countries and
hence not discussed.

6. Implications
In this section we analyse more comprehensively the different issues raised in the previous discussion.

21

6.1. Theoretical Implications

At the theoretical level, our improvements to the chain-linked model can be grouped under three categories: i) the distinction between knowledge and information; ii) the importance of taking account of
the environment; and iii) the characteristics of the firm.
The distinction between knowledge and information sheds light on the processes of diffusion and absorption. On the one hand, a certain level of firm-based knowledge is developed through production
and R&D activities, that is needed for absorbing information spillovers. On the other hand, this same
knowledge is characterised by its stickiness, and hence can only difficultly be transferred, which in turn
complicates the transfer of information.
The environment in which the firm operates is crucial. The market size determines the incentives available for domestic innovation, and the appropriation mechanisms determine the extent to which the returns from innovation are internalised. These also determine the extent to which spillovers exist in the
industry, while the structure of the market is often correlated to the absorptive capacity of the firms in
the industry. In LDCs, traditional knowledge exists as a differentiated source of information that can
provide a basis for original innovation and hence, a comparative advantage in these activities. Finally,
the environment also entails such resources as the quality and availability of human capital, which directly affects the firms capacity to conduct innovation, and is subject to different types of transaction
costs that affect the extent to which the firm can perceive feedback from the market and hence react
appropriately.
The last aspect is more difficult to integrate in a framework but needs to be taken into account, for it
affects the capacity to innovate and points towards other omissions or implicit assumptions of the
chain-linked model. The size of the firm is correlated with its capacity to conduct R&D (and hence its
absorptive level), to diversify its activities (and hence reduce risk) and to finance the innovation process. For small firms, the presence of risk and capital markets is hence vital, which is assumed given by

22

the chain-linked model and not discussed. However, in LDCs these markets can be absent or weak,
which further complicates the performance of innovation.
6.2. Policy Implications: Developing Countries
The three aspects discussed above can be improved upon if the government provides the necessary
public goods supporting the innovation process. Absorptive capacity and the need to access and be able
to use spillovers is key to the innovation process. Therefore investments in education, to raise human
capital levels, scientific capabilities and the capacity to absorb local or international spillovers, are central for a well functioning innovation policy, and more so where these resources are scarce. In countries
where absorptive capacity allows taking advantage of spillovers, but where inventions are not radical
enough to meet patenting requirements, IP legislation should favour the diffusion of information, as far
as the policy space allows it. However, given the importance of traditional knowledge as a potential
source of comparative advantage, it could be important to develop appropriate forms of IP protection to
ensure that this information is protected from foreign exploitation, or that appropriate compensation is
obtained for its use.
With respect to the environment, it is also of the resort of the government to provide institutions,
among others a functioning legal system, that provides a stable frame in which firms can operate and
enforce their rights. In the same line of thought, even though transaction costs are inevitable, reducing
their importance, and that of corruption, would allow firms to better perceive market feedback and
hence increase their efficiency in innovation. The development of bigger markets in LDCs is a longterm process, but an export-oriented strategy can provide greater incentives for local innovation, if
government refrains from taxing the exports of successful industries.
Finally, the improvement of firm-related aspects is a long-term process, but government intervention
providing or supporting the development of complementary markets and inputs such as functioning
capital and insurance markets would compensate for the lack of internal capacity. Similarly, invest-

23

ments in input markets and marketing infrastructures create other public goods that, through solving for
coordination and information failures, could significantly improve the climate for innovation.

7. Conclusion
This paper reviews the perspectives on innovation from the different branches of the economic literature to identify areas of further research and, more importantly, build a holistic conceptual framework
including these various contributions. Empirical evidence shows that the innovation process could follow a different pattern in developing countries. We hence modify our conceptual framework to better
represent the case of developing countries, and set the bases for future work in this area.
In general, more research is needed on the link between firm size and innovation, as well as on market
structure and innovation, where the theory and empirical evidence tend to be inconclusive. A methodological challenge would be to empirically distinguish between knowledge and information, and find out
more about their respective roles for innovation. But an important and necessary step would be to substantiate the evidence in LDCs to support the development of a more appropriate theory. Given the
importance innovation could have for these countries development, it should be set as a priority.

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