Innovation Systems and Digital Transformation

When you hear the word ‘innovative’, what comes to mind? You may think of a firm providing products or services by making full use of state-of-the-art technologies such as artificial intelligence (AI) or a firm producing such technologies. Innovation is a key growth factor not only for firms but also for nations. Innovative firms generate more value added than non-innovative firms. The more innovative firms there are in an economy, the more qualitative products and services are provided to the market with a more efficient method of production, which means the better the living standards (income levels) the people living in the economy enjoy. An innovative nation or economy has an environment conductive to generating innovative firms. It has highly competitive universities attracting talented people. It generates many start-ups, and venture capitalists gather there. When looking at innovative economies, we find that systematic linkages exist between universities, firms, investors, and related organisations. This finding applies not only to established developed countries like the G7 members, but also to newly developed countries like the Asian Miracles – the Republic of Korea (henceforth, Korea), Taiwan, Singapore, and Hong Kong. This chapter discusses optimal innovation systems at the macroeconomic level for middle-income Association of Southeast Asian Nations (ASEAN) Member States (AMS). As an introduction, we give a brief overview of the discussion. Many AMS are middleincome countries, and their technology utilisation levels are much lower than those of high-income advanced countries such as the United States (US). Economic growth theory implies that closing this technology utilisation gap is a primary way of turning middle-income countries into high-income countries as quickly as possible. For middleincome AMS to improve their technology utilisation levels, they need to understand the mechanism of technology adoption – both at the firm level and at the macroeconomic level – and build their innovation systems by harnessing digital transformation. Many AMS have advanced to middle-income status by participating in global value chains, based on their comparative advantage in labour costs amid globalisation. More precisely, AMS have improved their income levels by attracting foreign direct investment (FDI) to manufacturing plants through competitive multinational enterprises by providing low-cost labour resources. Moreover, indigenous firms that trade with global firms have improved their productivity through learning effects. It may appear that this growth model is sufficient for economies to grow to high-income levels since advanced technologies are likely to flow to AMS through FDI, typically in the manufacturing sector. However, what we have observed is the middle-income AMS struggling with overcoming the ‘middle-income trap’. In examining the differences between Asian Miracles cases and economies that remain at middle-income levels, it is difficult to find economies that have reached high-income levels through FDI alone. All the Asian Miracles that succeeded in establishing innovation systems, building innovation capabilities, and fostering competitive private firms in their countries did so by developing a healthy competitive market environment. For middle-income AMS to develop innovation-friendly markets, they need to keep in mind the lessons from empirical studies regarding technology diffusion from global frontier firms to national firms. First, promoting global-level firms in a country benefits other national firms – although national laggers seem to have difficulty adopting technologies directly from global frontier firms. Second, fostering global-level firms requires encouraging entrepreneurship, FDI for global innovative enterprises, an improved educational system, research and development (R&D) activities, industry–university R&D partnership, and an effective intellectual property rights system. Third, minimising inefficient and incapable firms contributes to improvements in macro-level innovation capabilities. To do so, it is necessary to balance the benefits of employment protection and costs of employment allocation inefficiency regulations and to reduce administrative costs for businesses. Last, to help national laggers catch up, product market laws and employment protection must be relaxed and industry–university R&D cooperation must be encouraged. From the perspective of indigenous firms or start-ups hoping to be global-level innovative firms in their economies, it is difficult for them to avoid competing with global frontier firms in high-tech industries, such as electronics, machinery, pharmaceuticals, aerospace, transport equipment, software, information technology (IT), and science and technical services. Competitive firms in both the Asian Miracles – Hong Kong, Korea, Singapore, and Taiwan – and China undertook creative imitation innovation strategies,and can provide lessons for latecomer firms competing with advanced firms in high-tech industry markets. Creative imitation is an innovative activity in which latecomers try to partly imitate and adapt new products and services from abroad to satisfy local market demands or to create lower-cost versions to compete in price-sensitive markets. It is an important option for firms in the middle-income AMS. Another important point in the promotion of innovative firms is full utilisation of digital transformation. The Asian Miracles succeeded in reaching the technological frontier before or around the 1990s, before the information and communication technology (ICT) revolution started in full swing. The current digital transformation trend has changed the importance of start-ups relative to incumbent firms in innovation compared with the Asian Miracle era. The significance of start-ups has been a major driver of innovation, especially in sectors such as e-commerce, mobile applications, finance, and the internet of things. ICT, or digital technology, has a property of general-purpose technology (GPT): it will be deployed in all sectors – both manufacturing and non-manufacturing – and make current business models obsolete. The digitalisation tide never turns, so both the private and public sectors in AMS economies must advance by shifting weight from accumulated ‘incremental’ innovation (typically in the manufacturing sector) to ‘disruptive’ digital innovation (adopted in all sectors). Technology utilisation gaps embody the potential to grow quickly by catching up with and even leapfrogging to a higher development stage – through the ‘advantage of backwardness’. To do this, AMS governments must keep in mind that supporting firms arbitrarily will not help to create innovative firms. Such industrial policies are not justified either theoretically or empirically. Pro-innovation industrial policies should keep the market competitive and impose strict accountability. In addition, AMS governments should establish innovation systems in which a government organisation oversees and coordinates the formulation and implementation of innovation policies across several government departments. They should also provide monetary incentives to the private sector, including local and international firms, to invest in R&D for innovation. Moreover, they should promote university–industry cooperation (UIC), which is an important component of innovation ecosystems that foster technological diffusion and knowledge spillover. This chapter is organised as follows. Section 2 breaks down productivity gaps into three factors – reproducible capital, human capital, and total factor productivity (TFP) – amongst AMS, East Asian countries, and the US. Section 3 claims the importance of TFP in economic growth by using macroeconomic models. Section 4 shows the movements of TFP of AMS and East Asian countries in recent decades. Section 5 explains the relationship between TFP and innovation capability, and shows what the ‘advantage of backwardness’ is via macroeconomic modelling. Section 6 presents a mathematical expression of macro-level innovation capability as the aggregation of individual firmlevel innovation capability, and discusses empirical findings on technology diffusion from global frontier firms and national firms. Section 7 explains that digital technology has the nature of GPT and discusses empirical findings regarding the relationship amongst digital technology adoption, firms’ capability, and market incentives. Section 8 discusses optimal innovation systems, harnessing digital transformation, for middle-income AMS to conclude this chapter.