The risk-reward nexus in the innovation-inequality relationship: who takes the risks? Who gets the rewards?

TL;DR: In this paper, the authors present a framework, called the Risk-Reward Nexus, to study the relationship between innovation and inequality, arguing that it is the collective, cumulative, and uncertain characteristics of the innovation process that make this disconnect between risks and rewards possible.

Abstract: We present a framework, called the Risk-Reward Nexus, to study the relationship between innovation and inequality. We ask the following question: What types of economic actors (workers, taxpayers, shareholders) make contributions of effort and money to the innovation process for the sake of future, inherently uncertain, returns? Are these the same types of economic actors who are able to appropriate returns from the innovation process if and when they appear? That is, who takes the risks and who gets the rewards? We argue that it is the collective, cumulative, and uncertain characteristics of the innovation process that make this disconnect between risks and rewards possible. We conclude by sketching out key policy implications of the Risk-Reward Nexus approach.

Summary

1. Introduction

• Inequality has hit the front pages, not only because it has been increasing, but also because of a seemingly inexorable concentration of income at the top of the distribution through boom and bust (OECD, 2008).
• By embedding their analysis in the collective, cumulative, and uncertain characteristics of the innovation process, the authors can ask who contributes labor and capital to the process and who reaps the financial rewards from it.
• And, as the authors will argue below, to understand this process, it is fundamental not to confuse value that is created in organizations with value that is extracted through “markets”.
• In Section 2, the authors lay out the conceptual foundations for understanding how innovation may be related to inequality by focusing on its core characteristics -- the collective, cumulative, and uncertain character of the innovation process.

3. The Risk-Reward Nexus

• The cumulative character of the innovation process creates a time-lag between the bearing of risk and the generation of returns that can enable some economic actors to “position” themselves strategically in order to extract more value from the returns to the innovation process than the “value-added” that their contributions of labor and capital create.
• From this perspective, the agency-theory argument that shareholders are the only economic actors who invest in the economy without a guaranteed return may serve as an ideology for those who claim to be representing the interests of public shareholders to appropriate returns that, on the basis of risk-taking, should be distributed to taxpayers and workers.
• The State can allocate these gains to support innovation through infrastructural investments or through subsidies to businesses and households designed to encourage innovation.
• But in the subsequent economic decline, in part induced, the authors would argue, by the success of the  13 value-extractors in concentrating returns in their own hands, workers and taxpayers typically lose out permanently even as the value-extractors use their control over corporate resource allocation to continue to look for ways to consolidate their gains.

4. Financial Actors and Value Extraction

• Well-developed markets in inputs and outputs can enhance the ability of the possessors of capital and labor to extract value.
• Rather than income being distributed equitably (which of course does not necessarily mean equally) according to the value that different economic actors create, certain types of economic actors are able to make use of both the reality and ideology of markets to extract disproportionate amounts of value for themselves.
• Financial deregulation and the spread of stock-related pay have enabled investors (especially of private equity) and top corporate executives to secure ownership of assets just before major innovation-related gains are capitalized into them.
• Let us give two important examples based on the U.S. experience of how this excessive value-extraction process works.

4.1 Value extraction through high-tech startups

• In October 1980 Genentech, founded in 1976 by venture capitalists and scientists, was the first dedicated biopharmaceutical company to do an IPO.
• The allocation of access to shares in an IPO favors insiders, including the Wall Street banks that underwrite the deals.,.
• The foundation for the emergence of the U.S. venture-capital model was the rise of the microelectronics industry in Silicon Valley from the late 1950s (Kenney and Florida 2000; Lazonick 2009b, ch. 2).
• Given the massive amount of funds that have flowed into the U.S. biopharmaceutical industry and the relatively small number of successful drug discoveries, the overall returns in terms of drug development have been small while financial interests, including highly remunerated biopharma executives, have, nevertheless, taken home huge sums (Lazonick and Sakinç 2010).
• At the same time, however, the average gains from exercising options of the five highest paid Microsoft executives were about 100 times that of the average gains of Microsoft employees (Lazonick 2009b, ch. 2).

4.2 Value extraction through established companies

• Unlike many other high-tech companies, the stock market was of little if any importance in inducing startup capital to back Microsoft in its early stages.
• The stock market was, however, very important for Microsoft in the  24 early 1980s to induce software engineers, computer programmers, and other technical personnel to forego secure employment opportunities with established companies like IBM, Hewlett-Packard, Motorola, and Texas Instruments to work for a still uncertain new venture.
• Given the fact that in the United States companies are not required to announce the dates on which they actually do open market repurchases of their own shares, there is an opportunity for top executives who have this information to engage in insider trading by using this information to time option exercises and stock sales (Fried 2000 and 2001).
• If the authors assume that named executives whose corporate compensation was below the $1.5 million threshold were able to augment that income by 25 percent from other sources, then the number of named executives in the top 0.1 percent in 2008 would have been 5,555 (Lazonick 2012a).

5.1 Analytical Implications

• By generating real productivity gains, innovation can potentially increase the incomes of all participants in the process.
• While SBTC makes “technical change” central to its analysis of the changing income distribution, it has no theory of innovation or even risk-taking.
• Given the growth in income inequality in the 1980s and 1990s, SBTC proponents assumed that a growing premium to collegeeducated workers was caused by the bias of the computer revolution of the time that increased the demand for the types of skills that college-educated workers have relative to less educated members of the labor force.
• The RRN approach argues that organizations generate innovation, and that because of the collective, cumulative and uncertain character of the innovation process, certain economic actors can, by gaining control over the allocation of resources within these organizations, appropriate rewards from the innovation process that are disproportionate from the risks that they took in that process.
• The SBTC approach argues that markets determine both the diffusion of technology and the returns to different types of labor, with the skill-biased characteristics of that technology affecting the demand for labor with different types of skills.

5.2 Policy Implications

• The policy agenda that flows from the Risk-Reward Nexus approach is fundamentally different from that which arises from a “market failure” understanding of inequality (such as the one embedded in the SBTC approach).
• Indeed by focusing on the risk-reward nexus in the innovation process, the authors believe the economic system will perform better and generate more tax receipts that can then be used by the State for such retraining purposes for existing technologies as well as investing in the next round of new technologies.
• In the U.S. case, the sums that could be diverted from buybacks are significant: about $2.6 trillion for 459 S&P 500 companies over the past decade, representing about 54 percent of net income.
• And rather than creating myths around certain actors (the hyping up of VC or SMEs), it is fundamental to recognize the stages at which the actors are important, along the risk space.

Full text

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The Risk-Reward Nexus in the Innovation-Inequality Relationship
Who Takes the Risks? Who Gets the Rewards?
by William Lazonick and Mariana Mazzucato
forthcoming in (Summer, 2013) Industrial and Corporate Change
Special Issue on: Finance, Innovation and Growth (ed. by M. Mazzucato)
Abstract. We present a new framework, called the Risk-Reward Nexus, to study the
relationship between innovation and inequality. We ask: What types of economic actors
(workers, taxpayers, shareholders) make contributions of effort and money to the
innovation process for the sake of future, inherently uncertain, returns? Are these the
same types of economic actors who are able to appropriate returns from the innovation
process if and when they appear? That is, who takes the risks and who gets the rewards?
We argue that it is the collective, cumulative, and uncertain characteristics of the
innovation process that make this disconnect between risks and rewards possible. When,
across these different types of actors, the distribution of financial rewards from the
innovation process reflects the distribution of contributions to the innovation process,
innovation tends to reduce inequality. When, however, some actors are able to reap
shares of financial rewards from the innovation process that are disproportionate to their
contributions to the process, innovation increases inequality. The latter outcome occurs
when certain actors are able to position themselves at the point where the innovative
enterprise generates financial returns; that is, close to the final product market or, in
some cases, close to a financial market such as the stock market. These favored actors
then propound ideological arguments, typically with intellectual roots in the efficiency
propositions of neoclassical economics, that justify the disproportionate shares of the
gains from innovation that they have been able to appropriate. These ideological
arguments invariably favor shareholder contributions to the innovation process over both
worker contributions and taxpayer contributions. Ultimately, precisely because innovation
is a collective and cumulative process, the imbalance in the Risk-Reward Nexus not only
results in greater inequality but also undermines the innovation process itself. In this
paper we 1) develop the Risk-Reward Nexus framework on the basis of a theory of
innovative enterprise that focuses on the collective, cumulative, and uncertain character
of the innovation process, 2) critique the leading economic ideologies that, by distorting
the relation between risks and rewards, have justified growing inequality over the past
three decades or so, and 3) apply the analysis to the trajectories of both innovation and
inequality in the U.S. economy since the 1970s. We conclude by sketching out key policy
implications of the Risk-Reward Nexus approach.
Key Words: innovation, risks, rewards, growth, inequality.
JEL Classification: 014; 015; 031
About the authors: William Lazonick (william.lazonick@yahoo.com) is Professor and
Director of the UMass Center for Industrial Competitiveness, and President, The
Academic-Industry Research Network (www.theAIRnet.org). Mariana Mazzucato
(m.mazzucato@sussex.ac.uk) is RM Phillips Professor in Science and Technology Policy
at the University of Sussex (SPRU). Both authors acknowledge funding from INET, the
Ford Foundation and from the FP7 FINNOV project (www.finnov-fp7.eu).

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1. Introduction
Inequality has hit the front pages, not only because it has been increasing, but also
because of a seemingly inexorable concentration of income at the top of the distribution
through boom and bust (OECD, 2008). And it is the concentration of income among the
top 1 percent, and even top 0.1 percent, that has become increasingly central to the
growth of income inequality. This has put pressure on national and transnational policies,
such as those of the European Commission, to focus not only on ‘smart’ growth, but
growth that is also ‘inclusive’ and ‘sustainable’—recognizing that not all have benefitted
from the knowledge economy (EC 2020, OECD 2012). However, the battle against
increasing inequality has had little success, as witnessed in the failed attempt to curb
bank bonuses after the 2008-2009 financial crisis.
A prime reason for this failure is a lack of understanding about how income inequality is
connected to processes of wealth creation. Indeed, one of the decades in which growth
was the ‘smartest’ (innovation led)—the 1990s—was a decade in which inequality
continued to rise. Or put another way, value was created (in the form of new
technologies, like the internet, and sectors), but then extracted and distributed to a small
percentage of those who contributed to the process of value creation. And while different
approaches have provided interesting insights into the dynamics of inequality, linking it to
the welfare state (Wilkinson 2005), globalization (Mazur 2000), de-unionization (Freeman
1992), and the changing skill base (Acemoglu 2002; Brynjolfsson and MacAfee 2011),
little attention has been paid to the tension between how value is created and how value
is extracted in modern-day capitalism.
In this paper, we argue that to understand income inequality it is critical to focus on its link
to wealth creation, and thus with innovation—a key characteristic of capitalism.
Innovation, defined in economic terms as the generation of higher quality products at
lower unit costs at prevailing factor prices, underpins real per capita income growth, and
therefore creates the possibility for higher standards of living to be shared among the
population.
1
But investment in innovation, whether incremental or radical, is inherently
uncertain; if we knew how to innovate when investments in innovation were made, it
would not be innovation.
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1
We define innovation in economic terms as the process that generates higher quality products at lower unit
costs so that our conception of innovation encompass all types of productivity gains, whether they derive
from “radical” or “incremental” innovation, or some type of innovation in between. We qualify this definition
of innovation with the condition that these productivity gains are achieved “at prevailing factor prices” to
exclude cases where unit costs are lowered by suppressing returns to particular economic actors, e.g., by

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In the first instance – that is before the State seeks to influence the level of inequality
through income transfers– one might expect that those economic actors who take the
risks of investing in the innovation process would be the ones to reap the rewards when
the innovation process succeeds and suffer the losses when it fails. By rooting our
analysis of the risk-reward nexus in a theory of innovative enterprise, however, we show
how in modern capitalist economies there has been an increasing separation between
those economic actors who take the risks of investing in innovation and those who reap
the rewards from innovation. Specifically, we argue that while risk-taking has become
more collective—leading to much discussion about open innovation and innovation
ecosystems—the reward system has become dominated by individuals who, inserting
themselves strategically between the business organization and the product market or a
financial market, and especially the stock market, lay claim to a disproportionate share of
the rewards of the innovation process.
A major barrier to the analysis of the relation between innovation and inequality is the
division of labor among economists between those who study each of these two
phenomena, and their mutual neglect of the role of financial institutions in linking the two.
While the relation between the production of output and the distribution of income was a
concern of nineteenth-century classical economists such as David Ricardo and Karl
Marx, research is now conducted on the basis of a largely segmented division of labor in
which labor economists work on inequality, and industrial economists on technology –
with both these groups typically ignoring the role of finance in the economy.
Since both innovation and income distribution depend fundamentally on the investment
strategies and organizational structures of business enterprises, we need a theory of
innovative enterprise that can explain both the creation of value and its distribution
among participants in the firm. A theory of innovative enterprise must integrate an
understanding of the interaction of strategy, organization, and finance in the generation of
higher quality, lower cost products than had previously been available (Lazonick 1991
and 2010; O’Sullivan 2000). We need a theory of innovative enterprise to explain how
over time the economic system augments its value-creating capability and the potential
for higher standards of living. If we do not have a theory of value creation, how can we
differentiate value that is created and value that is simply extracted (what some called
“rent”)? That is precisely what the Risk-Reward Nexus (RRN) approach aims to analyze.

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In conceptualizing RRN, we emphasize the collective, cumulative, and uncertain
character of the innovation process. Innovation tends to be collective because the
development and utilization of productive resources is an organizational process that
involves the integration of the skills and efforts of people with different hierarchical
responsibilities and functional specialties through a network of institutions and
relationships.
Innovation tends to be cumulative because what the innovative
organization learned yesterday becomes the foundation for what it can learn today.
2
Innovation, however, is also uncertain because when investments in the collective and
cumulative innovation process are being made, there is no guarantee that the enterprise
will be able to generate a higher quality, lower cost product
Yet, notwithstanding this uncertainty, people contribute effort (labor) and money (capital)
to the innovation process without a guaranteed return. That is, in the face of uncertainty,
they make their own personal calculations about the ‘rewards’ that may result from
participation in the innovation process which induce them to take ‘risks’. And, precisely
because the outcomes of the innovation process are uncertain, an ideology of who takes
the risks can, and we argue in fact does, influence who appropriates the rewards. By
embedding our analysis in the collective, cumulative, and uncertain characteristics of the
innovation process, we can ask who contributes labor and capital to the process and who
reaps the financial rewards from it. Then we assess the equity of this risk-reward nexus
(i.e. the degree to which rewards are proportional to the risks taken), and ask whether it
supports or undermines the innovation process.
3
The RRN framework starts with the
analysis of the innovation process as it occurs at the level of the product and builds up to
the level of the firm, industry, nation, and region (e.g., the EU).
Our explanation is based on how some actors position themselves along the process of
innovation to extract more value than they create, while others get out much less than
that which they put in. The power to engage in such excessive value extraction does not
occur through “exchange” relationships in which the contributions of some economic
actors are “undervalued” by the market. Rather it occurs when certain economic actors
gain control over the allocation of substantial business organizations that generate value,
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2
The cumulative character of the innovation process does not imply a model of innovation as a linear
process that begins with basic research and proceeds through development and applied experiments until its
introduction in mass markets. As explained also by the Systems of Innovation approach (see Freeman 1995),
the process is full of feedback loops, e.g., from market to technology, from application to science, or from
policy to innovating organizations. See chapter 3 in Mazzucato (2011) for a summary of the Systems of
Innovation perspective.
3
By equity, we mean a division of the gains from innovation in proportion to the productive contributions
that different actors have made to the innovation process.

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and then use product or financial markets on which the enterprise does business to
extract value for themselves.
Indeed, while the recent emphasis on “pre-distribution” focuses on the need to prevent
unequal market outcomes that create a “winner takes all” dynamic, which redistribution
policies must then fix (Hacker and Pierson 2010), we argue that understanding the
mechanisms behind “winner takes all” requires distinguishing between the source of the
disproportionate value extraction and its consequences (e.g., weaker labor unions, low
investment in skills). While we recognize that greater investments must be made in
education and re-skilling the workforce (policies arising from the “pre-distribution”
debate), we claim that the increasingly financialized economy has created incentives for
companies to not invest themselves in human capital and innovation, while increasingly
depending on those investments to come from elsewhere—mainly the public sector but
also from niche “small” firms. State investments and subsidies that are supposed to
support and encourage innovation often only serve to permit companies to get off the
hook of making these risky investments themselves even as their executives deliberately
make no mention of State support. Indeed they invoke “free market” ideology to claim
that, having taken all the risks, “private enterprise” needs to reap all the rewards.
Our analysis focuses on the concrete ways that financial interests have been able to
position themselves along the investment and innovation curve, reaping excessive
portions of the integral under the curve rather than just its marginal contribution. And, as
we will argue below, to understand this process, it is fundamental not to confuse value
that is created in organizations with value that is extracted through “markets”.
In Section 2, we lay out the conceptual foundations for understanding how innovation
may be related to inequality by focusing on its core characteristics -- the collective,
cumulative, and uncertain character of the innovation process. In Section 3, we then
sketch out the RRN framework for analyzing the innovation-inequality dynamic. In
Section 4, we use this framework to provide an historical overview of how over the past
few decades in the United States “financialized” modes of resource allocation have
become characteristic of both high-tech startups and established companies, increasing
income inequality while undermining the innovation process. In Section 5 we compare
the RRN framework to the Skill-Biased Technical Change (SBTC) framework,a widely
invoked approach to understanding the relation between, and the policy implications of,
“technological change” and inequality. Unlike the SBTC in which both skills and

Frequently asked questions

Q1. What are the contributions in this paper?

The authors present a new framework, called the Risk-Reward Nexus, to study the relationship between innovation and inequality. In this paper the authors 1 ) develop the Risk-Reward Nexus framework on the basis of a theory of innovative enterprise that focuses on the collective, cumulative, and uncertain character of the innovation process, 2 ) critique the leading economic ideologies that, by distorting the relation between risks and rewards, have justified growing inequality over the past three decades or so, and 3 ) apply the analysis to the trajectories of both innovation and inequality in the U. S. economy since the 1970s. 

Q2. How do the banks encourage a run-up in stock prices?

By keeping the float small, under-pricing the stock issue, and hyping the stock, the banks encourage a post-IPO run-up in stock prices as the investing public clamors for the listed shares. 

Q3. What is the importance of innovation in the economic agenda?

the importance of ‘intangible’ capital (patents, copyrights, design) appears on nearly every government’s growth agenda, as well as that of transnational  35organizations (OECD, 2012). 

Q4. What is the effect of the cumulative character of the innovation process?

The cumulative character of the innovation process creates a time-lag between the bearing of risk and the generation of returns that can enable some economic actors to “position” themselves strategically in order to extract more value from the returns to the innovation process than the “value-added” that their contributions of labor and capital create. 

Q5. How much of the company’s net income was paid out as dividends?

In addition the company paid out 49 percent of its net income as dividends, thus distributing a total of 138 percent of its net income to shareholders over the decade. 

Q6. What is the common reason for speculators to buy and sell stock?

including hedge funds, are willing to buy and sell on news about R&D contracts won or cancelled and clinical trials that succeed or fail. 

Q7. What were the first military technologies that were commercialized?

Military technologies that were later commercialized were developed by tens of thousands of scientists, engineers, and other technical personnel in research labs of larger ICT companies including AT&T, General Electric, IBM, Sylvania, Xerox, Motorola, and Texas Instruments. 

Q8. What is the main reason for the failure of the OECD to curb bank bonuses?

the battle against increasing inequality has had little success, as witnessed in the failed attempt to curb bank bonuses after the 2008-2009 financial crisis. 

Q9. When was the first dedicated biopharmaceutical company to do an IPO?

In October 1980 Genentech, founded in 1976 by venture capitalists and scientists, was the first dedicated biopharmaceutical company to do an IPO. 

Q10. Why has inequality hit the front pages?

Inequality has hit the front pages, not only because it has been increasing, but also because of a seemingly inexorable concentration of income at the top of the distribution through boom and bust (OECD, 2008). 

Q11. What is the argument that shareholders are the only economic actors who invest in the economy without a?

From this perspective, the agency-theory argument that shareholders are the only economic actors who invest in the economy without a guaranteed return may serve as an ideology for those who claim to be representing the interests of public shareholders to appropriate returns that, on the basis of risk-taking, should be distributed to taxpayers and workers. 

Q12. What is the RRN framework for analyzing the innovation-inequality dynamic?

In Section 2, the authors lay out the conceptual foundations for understanding how innovation may be related to inequality by focusing on its core characteristics -- the collective, cumulative, and uncertain character of the innovation process. 

Q13. How long does it take to produce a biopharma drug?

But it typically requires at least twice that amount of time to generate a biopharma drug that, having gone through phase 1, 2, and 3 clinical trials, the U.S. Food and Drug Administration may deem effective and safe enough to market. 

Q14. What is the reason why the biopharmaceutical industry has not been very productive?

Yet for all this government spending and the business funding that has flowed into the biopharmaceutical industry through private equity (including venture capital), IPOs, secondary stock issues, and R&D contracts, the biopharmaceutical industry has not been very productive (Demirel and Mazzucato, 2012; Pisano 2006).