Why large firms are often more inventive than small ones - Schumpeter: The Economist

SOME people say it is neither big nor clever to drink. Viz, a British comic, settled that debate with a letter from a reader who said: “I drink 15 pints a day, I’m 6 foot 3 inches tall and a professor of theoretical physics.” However, another question about size and cleverness has yet to be resolved. Are big companies the best catalysts of innovation, or are small ones better?

Joseph Schumpeter, after whom this column is named, argued both sides of the case. In 1909 he said that small companies were more inventive. In 1942 he reversed himself. Big firms have more incentive to invest in new products, he decided, because they can sell them to more people and reap greater rewards more quickly. In a competitive market, inventions are quickly imitated, so a small inventor’s investment often fails to pay off.

 

These days the second Schumpeter is out of fashion: people assume that little start-ups are creative and big firms are slow and bureaucratic. But that is a gross oversimplification, says Michael Mandel of the Progressive Policy Institute, a think-tank. In a new report on “scale and innovation”, he concludes that today’s economy favours big companies over small ones. Big is back, as this newspaper has argued. And big is clever, for three reasons.

First, says Mr Mandel, economic growth is increasingly driven by big ecosystems such as the ones that cluster around Apple’s iPhone or Google’s Android operating system. These ecosystems need to be managed by a core company that has the scale and skills to provide technological leadership.

Second, globalisation puts more of a premium on size than ever before. To capture the fruits of innovation it is no longer enough to be a big company by American standards. You need to be able to stand up to emerging-world giants, many of which are backed by something even bigger: the state.

Third, many of the most important challenges for innovators involve vast systems, such as education and health care, or giant problems, such as global warming. To make a serious change to a complex system, you usually have to be big.

If true, this argument has profound implications for policymakers (though Mr Mandel does not spell them out). Western governments are obsessed with promoting small businesses and fostering creative ecosystems. But if large companies are the key to innovation, why not concentrate instead on creating national champions? Anti-trust regulators have strained every muscle to thwart the creation of monopolies (for example, by preventing AT&T, a telecoms firm, from taking over the American arm of T-Mobile). But if one behemoth is likely to be more innovative than two smaller companies, why not allow the merger to take place?

What should we make of Mr Mandel’s argument? He is right that the old “small is innovative” argument is looking dated. Several of the champions of the new economy are firms that were once hailed as plucky little start-ups but have long since grown huge, such as Apple, Google and Facebook. (In August Apple was the world’s largest listed company by market capitalisation.) American firms with 5,000 or more people spend more than twice as much per worker on research and development as those with 100-500. The likes of Google and Facebook reap colossal rewards from being market-makers rather than market-takers.

Big companies have a big advantage in recruiting today’s most valuable resource: talent. (Graduates have debts, and many prefer the certainty of a salary to the lottery of stock in a start-up.) Large firms are getting better at avoiding bureaucratic stagnation: they are flattening their hierarchies and opening themselves up to ideas from elsewhere. Procter & Gamble, a consumer-goods giant, gets most of its ideas from outside its walls. Sir George Buckley, the boss of 3M, a big firm with a 109-year history of innovation, argues that companies like his can combine the virtues of creativity and scale. 3M likes to conduct lots of small experiments, just like a start-up. But it can also mix technologies from a wide range of areas and, if an idea catches fire, summon up vast resources to feed the flames.

However, there are two objections to Mr Mandel’s argument. The first is that, although big companies often excel at incremental innovation (ie, adding more bells and whistles to existing products), they are less comfortable with disruptive innovation—the kind that changes the rules of the game. The big companies that the original Schumpeter celebrated often buried new ideas that threatened established business lines, as AT&T did with automatic dialling. Mr Mandel says it will take big companies to solve America’s most pressing problems in health care and education. But sometimes the best ideas start small, spread widely and then transform entire systems. Facebook began as a way for students at a single university to keep in touch. Now it has 800m users.

The second is that what matters is not so much whether companies are big or small, but whether they grow. Progress tends to come from high-growth companies. The best ones can take a good idea and use it to transform themselves from embryos into giants in a few years, as Amazon and Google have. Such high-growth firms create a lot of jobs: in America just 1% of companies generate roughly 40% of new jobs.

Let small firms grow big

Politicians should certainly stop demonising big firms and sentimentalising small ones: an economy needs both. But they should not allow their new-found appreciation of big companies to degenerate into a taste for picking national champions. Such firms typically gobble subsidies and crowd out smaller, more creative firms. Nor should they start tolerating monopolies. The key to promoting innovation (and productivity in general) lies in allowing vigorous new companies to grow big, and inefficient old ones to die. On that, Schumpeter never changed his mind.