SEMINAR IN ECONOMIC POLICY RESEARCH THESIS Relationship Between Innovation and Economic Growth

By Muniba Khan 5473

ABSTRACT
The empirical studies to find the effects of numerous factors on growth are so extensive that even a summary of all would be impossible. This paper aims to focus on the evidence of one of those very important factors- the effect of innovation on growth. About time, for what we have seen; for what we have gone through recently, it has become imperative to analyze the affects of particular factors on growth to be able to forecast better and to track the most probable effects of lets say an act of innovation on an economy, on connected economies and on the world economy as the whole. This thesis has been designed to study the relevance between innovation and economic growth. The proof of which has been given through an econometric framework of Regression Analysis. The variables are represented with indexes constructed from an econometric regression. As dependent variables I have used the GDP growth rate. Using data from 15 countries selected on the basis of the ranking in the recent Competitiveness Report 2009-2010 (the report of 2011-2012 is due to be published on September 8th 2010), I have identified variables that affect the dependent variables. In the second part after introduction I have presented the relation between growth and innovation. In the third part I have presented the review of the literature in relation to innovation and growth. In the fourth part the empirical analysis is conducted with the help of the econometric framework and finally the last part concludes alongwith the comparison of the performances of the top rated countries with that of Pakistan. There are two main conclusions. The first is that innovation makes a significant contribution to growth. The second is that there are significant spillovers between countries, firms, and industries, and to a lesser extent from government-funded research.

TABLE OF CONTENTS
1 Introduction .........................................................................................................1 1.1 Point of departure and background.....................................................................1 1.2 Purpose .................................................................................. 1 1.3 Method.............................................................................................2 2 Innovations as the engine of economic growth ..................................................2 2.1 Innovation........................................................................3 2.2 Growth.................................................................................................................3 2.3 Relation between innovation and growth ...........................................................3 3 Literature review...4 4 Econometric framework.......................................................................................6 4.1 Multiple regression..............................................................................................7 4.2 Data and variables ...............................................................................................7 5 Empirical findings ................................................................................................7 6 Analysis .....................................................................................8 6.1 Analysis ...............................................................................................................8 6.2 Final words......................................................................................................... 11 7 References............................................................................................................ 12 8 Appendixes............................................................................................................ 13 8.1 Appendix A 8.2 Appendix B 8.3 Appendix C

Innovation and its Effect on Economic Growth-Research Paper PART I

INTRODUCTION 1. 1 BACKGROUND

For the past two years, the world has seen the worst ever mortgage crises, global financial crises, the steep surge in inflations and even steeper decline in production and productivity; at the same time the world has been a witness to the revolutionizing of business and economy through the power of innovation. It witnessed the empowerment of economies, companies and of the lives of individuals through knowledge and innovation. Innovation has left a huge impact on the way the businesses are done, politics, power and society. The increasing impact of innovation in the economic acceleration, development has therefore led to the complete change of how a business is conducted, how policies are made and how the business leaders have become responsible to create conducive environments to support and to welcome innovation and to let its effects to spill over for the benefit of the whole economy. Furthermore the importance of innovation has become so great that it has created its place on the international and domestic and public agendas. In other words innovation has a very positive effect on an economy and a country; otherwise the power mongers of the world would have no reason to impose technological sanctions on other countries. In the last decade, an increasing number of economists have come to conclude that innovation the creation and adoption of new products, services and business modelsis the key to improved standards of living. Soon after the World War II, almost all the countries of the world that value competitiveness embarked on a journey towards growth through maximum utilization of innovation and research and development activities conducted by the private as well as government sector. It is a constant debate that the role for government in the innovation process is naturally limited that this is a task solely for the private sector. It is true that that the private sector should lead, but in an era of globalized innovation and intensely competitive markets the federal government can and should play an important enabling role in supporting private sector and national innovation efforts. As pointed out by T. N. Srinivasan (Entrepreneurship, Innovation and Growth), besides private actors (innovators, entrepreneurs, firms, etc.), public non-profit motivated actors such as universities and research institutes (many of which, though autonomous, are funded largely by governments) and government agencies play an important role directly by spending on and doing research.

1.2 PURPOSE
With the discussion above in mind these problems raised my curiosity; innovation and growth - is there a connection? And if so how strong is it and what does it look like? Those were questions that led me in to this thesis problem area. In the following essay I have the intention to describe what factors affect the production of innovation in a country, for example how well educated the population is or how developed the soft infrastructure is. I have basically highlighted the factors that have a positive connection to, or that are an important factor for the growth at which innovations are generated.

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Further it would be interesting to study why some countries are better at getting the innovations to affect the economic growth. What makes countries such as the US better than China at putting successful innovations on the market? In this study my main purpose is to give a clearer empirical picture of innovation and its connection to economic growth.

1.3 METHOD
The regression is constructed as Multiple Regression and estimated in the program Microsoft Excel and further tested on SPSS. The material consists mainly of research articles concerning innovation and economic growth. It also contains reports from different research institutes and authorities like Insead and World Economic Forum. The data used in the regression is collected from different research institutes, mainly the World Development Indicators.

PART 2
INNOVATION AS AN ENGINE OF ECONOMIC GROWTH
This chapter is aimed to give a theoretical background to the connection between innovations and economic growth. This is to give an understanding of the forthcoming choice of economic growth model and to the choice of empirical study.

2.1 INNOVATION
We can define innovation for the purposes of the discussion as the implementation of a new or significantly improved product (good or service), or process, a new marketing method, or a new organizational method in business practices, workplace organization or external relations. Three points are underlined. First, innovation includes not only product and process innovations but encompasses new marketing methods and new organizational approaches. Second, innovation is not restricted to technology and knowledge creation through R&D, but also includes implementation or commercialization of advances in technology. Third, innovation is not restricted to a global first (i.e. the introduction/application of technology for the first time in the world), but includes the introduction/application of technology for the first time in a new environment. Such a broad view of innovation is appropriate as we are interested in innovation and diffusion of innovation as they affect growth both in developed and developing countries (Trade, innovation and growth, OECD, 2007) Innovation is important because it leads to the development of new products and technologies as well as it drives economic growth. However, productivity growth is the best aggregate measure of the economic consequences of innovation. The productivity of an economy can grow in two different ways. First, productivity can be increased by raising the value of goods and services produced. Second, productivity can grow by producing a given set of goods or services in a more technically efficient manner. Policy makers around the world, stress the first form, and give short shrift to the second, even though the latter approach is where most productivity gains come from. Raising productivity is not a matter of working harder or working longer hours. Making production more technically efficient requires getting more out of existing work hours, not raising the number of hours worked to achieve which firstly, government should subsidize both R&D and the training of workers in the use of leading-edge technologies. Second, government should

Innovation and its Effect on Economic Growth-Research Paper

help fill the financing gaps in the private R&D process, particularly for higher-risk, longer-term, and more generic research. Third, it should spur collaboration between firms and research institutions such as universities. Several advanced countries, are creating well-funded, sophisticated agencies to support innovation. In recent years many nations, including Finland, France, Iceland, Ireland, Japan, the Netherlands, New Zealand, Norway, South Korea, Sweden, Switzerland, and the United Kingdom, have either established or significantly expanded separate technology- and innovation-promotion agencies (Boosting productivity, innovation and growth through a National Innovation Foundation, Robert Atkinson and Howard Wial, 2008).

2.2 GROWTH
The global economy is on its way to achieving a historic growth record. With an annual growth rate of nearly 3.2% since 2000, the world economy grew more in the ten past years than in any ten-year period since the Second World War. With an increase of nearly 5% in 2007, some private think-tanks termed the last decade as one of its best decades ever. There was a major slump in 2009 but the recovery is fast on its way with the growth of the developing countries projected to rise by 5% in 2012. This economic expansion has happened in spite of a number of economic and political shocks: the collapse of the stock market bubble in 2000; the terrorist attacks of September 11, 2001; wars in Afghanistan and Iraq; the escalation of oil and commodity prices; a break-down in the Doha round of multilateral trade talks; some worrisome global imbalances and modest performances in some of the traditional engines of growth. Despite all this, the economic wheel is moving forward. What looked as a recent global economic slowdown turned out to be a "rebalancing" of growth. The slowing pace of activity in the US and Japan, which should remain well contained, is being compensated by an apparently solid upswing in the euro area According to several experts, China and India, along with other developing nations, are in a position to give the world economy its biggest boost since the industrial revolution. The participation of these countries in global economic flows has been increasing at a remarkable pace, representing now: more than half of total world GDP (if we measure it at purchasing power parity), 43% of world exports and nearly half of the world's energy consumption. In 2006 developing countries have grown at a near record 7%. During 2007 and 2008 they grew more than 6% per year, in comparison to a 2.7% GDP growth in developed economies. According to recent analysis by The Economist, if these trends continue, "it is estimated that in 20 years' time emerging economies will represent nearly two-thirds of global output (again, at purchasing-power parity)". How has the global economy managed to grow so steadily in a time of international uncertainty and recurring economic threats? Part of the answer lies in one single intangible factor: innovation.

2.3 THE RELATION BETWEEN INNOVATION AND GROWTH

Presently, it is common to suppose that new technologies are the driving force of the long run productivity growth. Countries can benefit from a high degree of external R&D, without great internal expenditures on R&D, through acquisition of rights for patents, franchising and exchange of goods in which external R&D is incorporated. There are externalities in innovation because countries are unable fully to appropriate the gains from their own innovation. The externalities occur in three main ways. First, technological spillovers reduce the cost of rival firms because of

Innovation and its Effect on Economic Growth-Research Paper

knowledge leaks, imperfect patenting, and movement of skilled labor to other firms. Second, network externalities may arise because the payoffs to the adoption of innovations may be complementary. Third, even if there are no technological spillovers, the innovator does not appropriate all the social gains from innovation unless she can price discriminate perfectly to rival firms (through licensing) and/or to downstream users. (Innovation and economic growth, G Cameron, 1996) The attraction of innovation as a determinant of growth in empirical research is its straightforward measurement. Researchers may use either input measures such as R & D expenditures or innovation outcomes such as patents (the way it has been done in this paper). A large body of empirical work has evolved from this focus on technological progress and innovation. These studies have established that the level of technological innovation contribute significantly to economic performance, particularly at the firm and industry level. Studies on the impact of technological innovation on growth have been predominantly based on the neo-classical tradition established by Solow (1956), where growth is driven by enhancements to capital and labor inputs, whether in terms of quantity or quality and productivity. More recently, researchers have begun to examine growth that is endogenously determined by technical change resulting from decisions of profit-maximizing agents. The latest class of models developed in this tradition has arisen from the works of Romer (1986, 1990), Grossman and Helpman (1991) and Aghion and Howitt (1992). In contrast to the Solow-like models, productivity growth results from intentional innovation by rational, profit-maximizing agents and is therefore endogenously determined. Endogenous growth models emphasize the importance of knowledge, knowledge spillovers and technological substitution in the process of economic growth, conceptually parallel to Schumpeter's early growth theory (Entrepreneurship, innovation and economic growth: Evidence from GEM data, 2005)

PART 3
LITERATURE REVIEW
Both theoretical and empirical literatures have shown that investments in R&D are crucial for economic growth. In the theoretical side, a lot of models (Romer, 1990; Grossman and Helpman, 1991; Aghion and Howitt, 1992) illustrate the function of R&D as a growth engine, and demonstrate the reason why government must have a role in achieving an optimum level of R&D. In the empirical side, several authors also show the importance of the R&D returns. Investments in R&D have been shown to be an important indicator of innovation activity of a country (Ulla Hytti & Pekka Stenholm) Technology and talent have long been seen as driving forces of economic growth. Solow (1957) long ago argued that economic growth relies upon technological change. Romer (1986) established the connection between knowledge, human capital, and economic growth through his endogenous growth model, arguing that investments in human capital generate spillovers and increasing returns. The seminal Lucas (1988) endogenous regional model noted that cities function to transfer knowledge and generate powerful human externalities that increase productivity and spur growth. The connection between human capital and regional growth is supported by a wide body of empirical evidence at the national and regional levels.

Innovation and its Effect on Economic Growth-Research Paper

The developed economies today are increasingly based on knowledge and innovation. In the knowledge-based economy the emphasis on knowledge as the driver of economic growth is evident. Focus is set on the role of information, technology and learning. The emergence of the information society has contributed with improved ways for distribution of innovations through communications such as the Internet (OECD 1996 p 1 &7). The early work of Schumpeter (1911) established conceptually the "entrepreneur as innovator" as a key figure in driving economic development. The innovative activity of entrepreneurs feeds a creative "destruction process" (Schumpeter, 1942) by causing constant disturbances to an economic system in equilibrium, creating opportunities for economic rent. In adjusting to equilibrium, other innovations are spun-off and more entrepreneurs enter the economic system. In this way, Schumpeter's theory predicts that an increase in the number of entrepreneurs leads to an increase in economic growth. Technological progress (Philippe Aghion, Peter Howitt, 1990) creates losses as well as gains, by rendering obsolete old goods, markets, and manufacturing processes. This has both positive and normative implications for growth. In positive terms, the prospect of a high level of research in the future can deter research today by threatening the fruits of that research with rapid obsolescence. In normative terms, obsolescence creates a negative externality from innovations, and hence a tendency for the generation of too much growth. Growth results exclusively from technological progress, which in turn results from competition among research firms that generate innovations. Each innovation consists of a new line of intermediate goods that can be used to produce final output more efficiently than before. The average growth rate and its variability are also affected by the extent of knowledge in the manufacturing sector of the economy. The greater the coefficient of knowledge, the more research will be undertaken. This will raise the average rate of growth attributable to research, but it may decrease the growth attributable to knowledge, because the only way for society to engage in more research is to take labor out of manufacturing (Philippe Aghion, Peter Howitt, 1990) While the main focus of empirical research has been the effect of R&D on productivity, a few studies have looked at the roles played by other measures of innovation. Studies by Geroski (1989) and Budd and Hobbis (1989) conclude that patenting, and imports of machinery from abroad (assumed to embody the latest technology) have a significant and positive effect on productivity (Gavin Cameron, 1998). This clearly explains the reason behind massive growth of those countries whose investment in R&D is comparatively lesser. The firms with an initially lower technology cannot immediately acquire a technological leadership through innovation, because they firstly have to reach the same level of the firms with the leading-edge technology and only after they can compete in order to achieve the leadership in the industry (Scopelliti, Alessandro Diego, 2009). Therefore, while comparing the countries, it has to be kept in mind that they are leveled in terms of innovative capability. Pakistan can not be out rightly compared to USA, which has a history of over 250 years, in terms of economic growth through innovation. However, it can be compared to India who started its development process with Pakistan. Openness to new ideas, solutions, etc. is considered essential for innovation projects, especially in its early phases. The principle reason for this has to with a fundamental characteristic of innovation: that every new innovation consists of a new combination of existing ideas, capabilities, skills, resources etc. Applied mechanically on a population of countries this logic

Innovation and its Effect on Economic Growth-Research Paper

might perhaps be taken to imply that large countries should be expected to be more innovative than small countries? However, modern countries are not closed systems comparable to isolated populations of ancient times. Countries have learnt, by necessity, to closely monitor each others steps, and search widely for new ideas, inputs and sources of inspiration. This greatly enhances the innovativeness of the countries. Arguably, this is of particular importance for smaller countries, which have to compensate for small internal resources by being good at interacting with the outside world. However, the growing complexity of the knowledge bases necessary for innovation means that even large countries increasingly depend on external sources in their innovative activity (Jan Fagerberg, 2003). Posner (1961) explained the difference in economic growth between two countries, at different levels of economic and technological development, as resulting from two sources; innovation, which enhanced the difference, and imitation, which tended to reduce it. This set the stage for a long series of contributions, often labelled technology gap focusing on explaining such differences in economic growth across countries at different levels of development. Fagerberg (1987, 1988) identified three factors affecting why growth-rates differ; innovation, imitation and other efforts related to the commercial exploitation of technology, as driving forces of growth.

PART 4
ECONOMETRIC FRAMEWORK 4.1 MULTIPLE REGRESSION
Multiple regression can be utilized for forecasting purposes. The method looks at how a number of variables have affected a dependent variable historically. From this, the relationship between these variables and the dependent variables can be expressed as; Y = A + B1X1 + B2X2 + .. + BnXn + E Where ; Y = Predicted dependent variable value A = The value of Y when all Xs are zero B = The coefficients corresponding to dependent variables X = The independent variables n = The number of independent variables E = an Error term By forecasting the independent variables, we can predict the dependent variable. However, to ascertain that the relationships are not coincidental, we must first assess the correlation between the dependent and the individual independent variables. We can apply this by a Pearson correlation coefficient (otherwise known as R) to each independent variable. This tells us how much a change in the dependent variable can be explained by the independent variable. Those variables with a high R-squared should then be used for multiple regression. The same correlation coefficient can be applied to multiple independent variables to ascertain how much of the change in dependent variable can be explained by changes in all independent variables. R-Squared = (BXY-nAVG(Y)^2)/(YY-nAVG(Y)^2) Where; B, X, Y = Matrixes of all possible combinations of B, X and Y respectively

Innovation and its Effect on Economic Growth-Research Paper

The adjusted R-Squared is calculated by correcting for the number of independent variables in multiple regression analysis. The formula Adj R-Sq = (1-(1-R-Sq)*((n-1)/(n-k))). It is often used to compare models involving different numbers of coefficients. The standard statistical significance of the multiple regression can be tested with a F-Test which can be derived from a normal probability distribution. A critical point along the distribution can be found given a degree of confidence required, the number of variables and the number of observations. If the F statistics is above this point then the analysis can be deemed statistically significant at this level of confidence. F-Statistics = (R Squared/(K-1))/((1-R Squared)/(n-k)) Where; K = Number of independent variables n = Number of observations Independent variables that are highly correlated themselves, can lead to high variance in the slope estimation (B). This is known as Multicollinearity, for this reason independent variables with high level of Multicollinearity with other independent variables are omitted from the analysis (as a rule of thumb the R-Sq of 90% would indicate this).

4.2 DATA AND VARIABLES

The data has been evaluated over 14 times periods which were chosen given the supply of data. By choosing the period between 1995 and 2008 I could collect data for almost all the variables during that time period. The variables that I have chosen have been selected on the basis of theories concerning innovation. The most evident problem is that variables that would be interesting to include in the indexes are hard to quantify and also that the research in this area is relatively new. Therefore, the reader should bear in mind that the variables that are included in the index were chosen from a limited range of variables. The selected variables that define innovation in any economy include patent applications, internet users, researchers, trade (as a % of GDP), employment in services, total employment to population ratio, businesses newly registered, lending interest rate, FDI, R$D expenditure and public spending on education

PART 5
EMPIRICAL FINDINGS
The data has been analyzed country wise individually to understand the relationship between various innovations and development the latter taken as dependent variable. Some of the results that have been derived from individual study of Australia suggest a positive correlation between various innovations and development in general. With an R Squared value of 0.99 and standard error of 0.04 a 95.95 % of change in annual GDP was explained by 11 of the independent variables adjusted for sample size bias and the analysis was significant. A Study of the independent variable suggest that theres a greater relationship between GDP growth and trade and employment ratio to population however the overall size of the sample limited a better understanding and most of the R-Squared values werent significant enough to

Innovation and its Effect on Economic Growth-Research Paper

conclude a positive correlation. As a rule of thumb R-squared values below 50% suggest a low correlation. The Multicollinearity analysis of various independent variables amongst them had various important things to suggest an understanding that there is a high correlation between Researchers (per million people) and expenditure on research and thereafter patent applications and employment and the number of internet users and employment to population ratio with the figures staying above 50%. However in various other cases the Multicollinearity was not as significant and most of the reading suggest a below 50% results. In the case of China the correlation is low in R&D expenditure and the number of researchers however the figures are over 50% in trade, FDI and the patent applications proving that Chinas growth is not due to its innovation due to research and development but due to the trade and imports of other countries. The statistical findings of the other countries is given descriptively in Appendix B and the statistical working is attached in Appendix C. The overall finding was that innovation impacts significantly the growth of the country. The most competitive states are ranked the highest because competitiveness comes from innovation and the results clearly show that most of these countries growth rests on their innovativeness. The results could not show a total positive relation because of the small sample size and the unavailability of some data.

PART 6
6.1 ANALYSIS
America has always been the leading innovator of all times, the car, the airplanes, the computer, the internet and most of the things we cannot survive without. Reaping the benefits of such innovations and inventions that America finds its self at the top of the food chain as the lone super power and the lone power monger. Germany has always been the hub of well oiled machinery. With x-ray, cathode ray tubes, fertilizers, hard disks, aspirin, spark plugs, MP3, electric motors, LCD technology and so much more that it isnt very surprising that out of all the Nobel prizes given in the world, over 10 percent have gone to Germany in the past 15 years alone. British havent been behind and were trying to catch up with their innovations and their much rivaled Americans. United Kingdom has had a gift of innovations in the field of forensics and medicine. DNA, finger printing, MRI, genetics, www,, vitamins, penicillin, stem cell technology, the Concorde, burglar alarm, radar, radio telescope and not to forget the infamous birth control have allowed the British civilization to put itself amongst the top of economic and social successes of all times. Sweden has refrigerator, telephone, cell phones, pace maker, wrenches, dynamite, light houses, stealth technologies, propellers, seat belts and a vast list of innovations under its flag and has rightfully placed itself at the higher performers at the innovation index. Similarly the European countries like Holland, Denmark, Finland, Denmark, Norway, Austria, France, Belgium etc have maintained their active presence in the extensive fields of technology,

Innovation and its Effect on Economic Growth-Research Paper

medicine, bio-technology, communication, and several other fields. They have a long record of R&D and innovations that have been of extreme economic benefits and growth. Japan is the pioneer of production lines, time motion study, space optimization, machine and vehicle technology and the father of quality products and production in the world. They have always remained as the quality bench mark for the rest of the world to be followed; similarly Australia, Korea, Taiwan, Singapore and similar countries have performed extremely well in the recent past. For all of the countries mentioned above, we notice a trend- a trend that can be summarized as countries who have innovated have had its great impact on its growth and overall wellbeingvery understandable indeed. We now turn out attention to some countries that show a substantial deviation from the trend we witnessed above. Pakistan since its inception has been unlucky when it came to innovation. Starting with meager facilities of its own, it went into the hands of feudal lords who made it sure that no one but them benefited from anything that the country could offer. The land, the factories, politics and governance were all captured and held by such people who felt threatened by anyone else enjoying economic improvement. Therefore the educated and much talented people of this county have always opted to drain out and work for more welcoming economies like America, Britain etc. The lone Nobel Prize winner was driven out on the basis of religion and politics form this free county who later on went to Italy to prove his capabilities. Then the investment in education, investment in human capital and infrastructure is minimal in the country and therefore there always is an acute shortage of quality worker and labor. The country is rich with natural resources like oil, coal, gold, copper, salt, gas, dams, uranium, different type of ores, a huge coast line, the worlds most top peaks and the weathers of all colors; still we see the country without the basic necessities like power, gas, water and food for its people. The natural resources remain unexplored and unutilized and where expensive power is being produced on expensive rental power plants while it could have been produced almost for free. The factories, industries are closing down doe to the exponential increase in the cost of production and the deteriorating political, social and security environment. The innovation in the country has mostly been in terms of policies set by the government, which more often become the reason for the corrupt to do more and the end users to suffer. For example, the governments decision to control and highly tax the import of imported vehicles was an innovative step aimed to focus on the growth of local industry was turned into a scam by the car manufacturers in Pakistan my making cartels and monopoly in collaboration with high-ups in the government and politics. Yet, of all the bad and worst as above, we have noticed Pakistan as the worlds second fastest growing economy after Singapore about 4 years ago. We witnessed the biggest cache of FDI, investment, opening of banks, businesses and a stock market which made and broke records every day and a GDP growth rate in double figures. China, the worlds largest population is one economic power that scares even the strongest of economies. China has been a good innovator, but the invention of noodles, rowing, rice cultivation, soy bean cultivation, gun powder, lacquer, daggers, compass, paper etc may not have had that a great impact on changing the world, but innovations indeed have benefited the Chinese economy and dictated the way of life.

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It is surprising that with not much of its innovation, China enjoys the healthiest economy and the highest growth rate in the world. It sells its products to every corner of the world and is able to flood the well regulated international markets with its low quality and cheap products. The world was suffering from a slump recently and china was fighting hard to keep its growth rate in control to maintain the inflation rate in check. China was ranked no. 37 on the Global Innovation Index -2008-2009, and was ranked 43rd in the GII 2009-2010, yet we witness its growth rate has been more than the top performer USA of the 2008-2009 period and Iceland, the top performer of GII 2009-2010. India too on the other hand has been average on the innovation scales but at the same time, as china its growth rates have been very good and its economy has been in a boom for several years now. The economic crisis did hurt its growth and businesses but not as much as the rest of the world. The economy has seen a steady growth and the business and services have seen a steady improvement. Surprising- but no surprise. Countries like Pakistan, China and India have deviated from the trend for reasons that could be explained by the innovation and technology itself. The innovation in technology, information technology and communication has shrunk the world in to a global village where everything is in reach for everyone, the cheapest suppliers can be reached, the cheapest labor can be reached, the most lucrative markets can be reached, the cheapest cost of production areas can be exploited and every good opportunity can be exploited for the benefit of the business. Therefore all the innovators of the world are on the look for cheaper places with cheaper labor and cheaper resources and raw material and easy laws. How does it work? Lets analyze. American company Apple came up with cutting edge innovations like iPod, iPhone, iPad. It made a great amount of business from the products indeed, but is it just American economy that has benefited from those innovations? No! Turn the products around and we see that they are all made in china; so in essence every iPad or iPod that Apple sells, it directly gives a positive effect to the Chinese economy. Dell, gets its products made from china, Intel, HP, and every major American product is made in china. Finland comes up with a new Nokia handset, they get it made from china, German cars have Chinese parts, Japanese TV sets are now made in china, the raw material for British medicines come from china, and the major portion of everything in the world is being made and supplied by china. Why? Because china has the cost edge, it has the labor edge, it has the cheap raw material edge and it has all the factors present in it for the other countries to be attracted to benefit from it and also to offer their products to the huge Chinese markets. Therefore the spill-over effect of an innovation becomes the reason for the positive growth of china and also due to the huge potential market for goods and services that it has to offer. Similarly, when a product is sold in America, money is made in India. The outsourcing of call centers and the web hosting has given the best to India. American products, made in America are sold to Americans on the phone or on the web from India, and thats where the cheap and educated labor class of India has played a huge role in its economic growth. Therefore India has been extremely successful in using its worlds 2nd largest population to attract business for it being cheap and being the 2nd largest potential market for goods and services offered by the companies across the world. Of course, an educated and talent workforce has helped it to become

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a big market for web development, software development and similar technological services for the foreign countries and companies.

6.2 FINAL WORDS

It indeed is true that innovation leads to and results in positive effects over an economy, but not alone. In this new era, the economic benefits of an innovation are not reaped by the innovator alone, but it actually enables other economies to benefit from it sizably. And in some cases the economic costs of the beneficiaries may be much less to the actual innovator as the initial cost of R&D gets avoided and it is much easier to produce and follow an innovation of someone else. Though the benefits of R&D are widespread; each firm will benefit from both its own R&D/innovation, as well as the research results/innovation of other firms, the domestic science base and research carried out by foreign governments and foreign firms. Patents, scientific literature, technology licenses, and technology embodied in capital and intermediate inputs, and personal contacts provide the means for research results to diffuse throughout the domestic and world economy. A number of externalities arise in the innovation process. First, the standing on shoulders effect of technological spill-over reduces the costs of rival firms because of knowledge leaks, imperfect patenting, and movement of skilled labor to other firms. Second, the surplus appropriability problem means that even if there are no technological spill-over, the innovator does not appropriate all the social gains from innovation unless she can price discriminate perfectly to rival firms (through licensing) and/or to downstream users. Third, the creative destruction effect means that new ideas make old production processes and products obsolescent. Fourth, stepping on toes occurs because congestion or network externalities arise when the payoffs to the adoption of innovations are substitutes or complements. Innovation can originate anywhere. Increased education and economic growth have improved the capacity of developing countries to offer new products and services. Modern communications and transportation technologies allow these countries to share advances with consumer across the globe. As a result, great ideas-regardless of where they originate-are less likely to be lost in our increasingly interconnected world. It is not a coincidence that countries such as USA or Japan are the worlds top economies because their allocation of resources into creating innovation is massive. It obviously indicates that innovation is the key driving growth and prosperity. Economists calculate that approximately 50% of US annual GDP growth is attributed to increases in innovation. For the past two centuries, the US has been the world-leader in developing innovative products and services. Innovation distinguishes between a leader and a follower.(Steve Jobs American Entrepreneur Apple co-Founder) I completely agree with this.

Innovation and its Effect on Economic Growth-Research Paper REFERENCES

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