Poverty traps and prototypesPosted: February 17, 2013
Notes on the practice of innovation and technology commercialization.
It was a bracing day in central Russia, the sun sparkling off ice crystals suspended in the still dry air, but the director of a physics and engineering research institute was worried. His institute employing some 700 researchers was working hard to build on its good reputation for innovation to increase its income from joint R&D contracts with industry. Several large domestic and foreign firms had negotiated new contracts with his institute, but these were mostly short term, for proof of concept or initial prototype developments. After these were completed the contracting firms said they would continue future work themselves. Some 5,000 miles away to the south west the sun was also shining, although the temperature was markedly higher, a West African small business owner was also worried. It seemed however hard she worked she could not earn her way out of depressing poverty.
What do the research institute director and the small business owner have in common? Both are caught in ‘traps’ – a ‘poverty trap’ for the small business person and a ‘positioning trap’ for the research institute.
Poverty traps have been heavily analyzed by economists and the concept is shown here only as a stimulant to solving the director’s problem through connecting apparently disparate circumstances. To paraphrase the discussion in the 2011 book Poor Economics by Abhijit Banergee and Esther Duflo: “There will be a poverty trap whenever the scope for growing income or wealth at a very fast rate is limited for those who have too little to invest, but expands dramatically for those who can invest a bit more.”
If your future income, as influenced by your income today, is lower than your income today, the growth curve is below the diagonal line as in the diagram on the left (the S curve) and you will become poorer and poorer. The 45 degree line represents income equality for present and future.
Banergee and Duflo point out that many economists believe that the world usually looks more like the diagram on the right (the L curve). “There is no poverty trap in this world: Because the poorest people earn more than the income they started with they become richer over time until eventually their incomes stopped growing. … A one-time gift in this world will not boost anyone’s income permanently. At best it can just help them move up a bit faster, but it cannot change where they are eventually headed.”
In the The Rainforest: The Secret to Building the Next Silicon Valley http://therainforestbook.com/ authors Victor Hwang and Greg Horowitt discuss (page 229) “how trust and normative behavior effect systemic financial returns. When actors in the Rainforest behaved in a way that significantly lowers the cost of doing business together, it shifts the entire [transaction cost] curve. Lowered transaction costs due to trust and social norms make high-risk seed-stage and early-stage venture capital investing more profitable.”
This diagram from the book shows risk adjusted capital in a diversified portfolio (vertical axis) and how reducing transaction costs (moving the cost curve to the left) enables earlier returns to be made, or as Victor and Greg put it “One can literally make more money when people get along better.”
Let me now try to connect these pieces. I will not touch on the controversies of using foreign aid to escape prototype traps; although the effect of reducing transaction costs through Rainforest principles is worth thinking about. Let’s return to the director’s need to escape the ‘positioning trap,’ at the bottom of the S curve, which has not been well studied (actually, I made up the term for this Blog). Carrying out and managing multiple small short-term contracts will normally have higher costs than for a large, long-term, institute/industry R&D project. Furthermore, short-term contracts are likely to produce few additional benefits, such as embarking on entirely new lines of scientific inquiry and improved access to current corporate R&D.
From what we have seen so far, to escape the ‘positioning trap’ the research institute should try to position itself to (1) provide relatively small amounts (compared with expected returns) of internal retained earnings and quickly accessible grant financing to demonstrate to a corporate partner that the institute has the capacity to move beyond proof of concept and early prototype R&D, and (2) reduce transactions costs by increasing trust levels – in fact (1) will help to do so. Trust building through improved communications will be the subject of a future Innovation Rainforest Blog.
Did applying these solutions help? Yes they did. The institute was able to be more selective about taking on short-term R&D contracts, and was able to obtain large long-term joint corporate R&D contracts yielding substantial income. A combination of retained earnings from other projects, internal budgets, and limited grant support was used to escape the ‘positioning trap.’
Early stage development grants are common but we don’t always think of them in terms of helping to escape the ‘positioning trap.’ By the way, we shouldn’t forget that we also need to deal with what happens when the top of the S or L curves is reached, but as academic papers in mathematics like to say “we will leave this to the interested reader.”
See a paper by Kiminori Matsuyama, On the Mechanics of Poverty Traps, http://faculty.wcas.northwestern.edu/~kmatsu/Poverty%20Traps.pdf for a discussion of poverty traps in economies from a dynamic (non-static) viewpoint.
Next time: Solving the right problems.