The R&D process is not very attractive1 to businesses. It is high risk, has low productivity, and requires expensive talent. A few businesses manage to incorporate it into their business model. However most do not, and are happy to adopt the output of other organisations’ R&D.
On the other hand, governments love the R&D process. Estimates of private rate of returns to R&D from numerous studies2 cluster around 10% to 15% (but can be significantly higher). Studies have also estimated the social rate of returns from R&D, from side-effects such as spillover and enhanced ability to adopt innovation. These estimates range up to 100%. Accordingly governments make great efforts to increase the levels of R&D within their economy.
These government efforts include:
In 2024/25, the Australian Government support for R&D is forecast to be $14.4 billion which is 0.52% of GDP.3
If you consider the market for the outputs from the R&D process (innovative products and services), it becomes apparent that this government support is targeting the supply side of the market. However a market cannot grow by increasing supply if there is no corresponding growth in demand. So to increase the amount of R&D undertaken within a country, government support should proportionally also target the demand side of this market.
The demand for innovative products and services (what R&D creates) differs from non-innovative products and services in that the demand also has to deal with adoption. This has been extensively studied under the field of innovation diffusion. Briefly, there are risks and change associated with adopting (buying) innovation. Innovation diffusion divides people into categories based on the extent to which they are prepared to bear the risks and changes in order to get the benefits of the innovations.
The category most likely to bear the risks are called “Innovators”4. It is estimated that about 2.5% of the population are innovators. Innovators drive demand for brand new innovations. The second and third categories are “Early Adopters” (13.5%) and “Early Majority” (34%). People in these 2 categories drive scaling for innovations. They have an ability to evaluate and deal with risk associated with innovation and incorporate that into their careers.
Let me illustrate this with 2 experiences in my career. (R&D purists may argue that these examples are not strictly R&D, however they are high-tech and innovative - sufficiently so to illustrate the demand side of the market for innovation.)
In the 1990’s I was a youngish project engineer working for a defence contractor building some ships for the navy. I was responsible for the delivery of the platform training facility and simulator. However this work had been subcontracted out to a multi-national defence firm (sub-contractor) - my job was to ensure that their deliveries met the navy’s requirements and successfully integrated with other part’s of the ship. It was a demanding task as this work was on the critical path and had to deal with delays in the ship’s design.
During the detail design phase of the simulator, the sub-contractor became aware of the need to simulate a sophisticated piece of electrical equipment on the ship. They advised that this was outside the scope of work they had contracted for and would require extra time and money to do this additional work. Naturally, at first we argued this was within the original scope but in the end, conceded that they had a valid point.
At that point, I assumed we would negotiate a variation to their contract which would require substantial payment, but more importantly, delay the delivery of the ship to the navy. However, the commercial manager I reported to, Kamal, had other ideas.
Kamal found a couple of electrical engineering lecturers at a university who also had a company which develops custom sophisticated electronic equipment. He asked myself and the engineering team to confirm that they had the ability to develop this simulation component, and then to negotiate an agreement with them to undertake this work. Kamal then authorised for us to proceed with this small firm to develop this critical piece of equipment required for the simulator.
In the end, they successfully, developed this simulation component to military standards, at a price far lower than the simulator sub-contractor would have charged and, most importantly, without an impact on the ship’s delivery schedule.
Personally, I was very impressed with Kamal’s approach. My experience at my employer, is that they only deal with large, established firms. When confronted with this problem, Kamal, who had an electrical engineering background, identified the opportunity to resolve this by working with a small innovative company and he had the ability to balance the risk against the benefits. Not only that, once he decided that the benefits outweighed the risk, he persuaded senior management that this was the right course of action.
What impressed me most was how he managed the personal risk to his career. If the small, university-aligned company had failed to deliver, much of the responsibility would have rested with him, and the resulting fallout would likely have harmed his career. Instead of playing it safe, he incorporated managed risk into his career.
Let me now relate an experience where (it seems) an organisation decided to play it safe by only dealing with large established businesses and failed to meet their objectives.
My company, Motif Markets, develops full stack trading platforms for security exchanges. It is a tough space for a small company as exchange operators like to deal with suppliers with large balance sheets (we mainly deal with startups).
A few years ago, a government organisation invited tier 1 exchanges to provide expressions of interest for the development of a carbon exchange. Tier 1 exchanges are typically integrators of expensive systems from different suppliers. It is unlikely that they could provide a solution that aligns with the revenue from a carbon exchange. However our product was an ideal solution - aligned with the requirements, in production use, and was largely off-the-shelf. So we conditionally partnered with a couple of tier 1 exchanges and submitted a response which we considered to have low technical risk and was very price competitive.
We knew it was a long shot and we were not particularly surprised when we were not short listed to tender.
Over the following 2 years it became apparent from the organisation’s website, that the tender was not proceeding well and it was then announced that the procurement process was closed without a successful tenderer. No progress has been announced since then.
I have no first hand knowledge as to why the tender process was not successful. It may have included reasons other than technical and price, however I believe that ignoring solutions from small innovative companies was a contributing factor.
While this lack of interest is frustrating for small innovative companies such as ours, it is important to realise that this is the result of a rational decision making process. Many organisations are risk averse. They attract and promote staff that who are in the “Late Majority” or “Laggard” categories of innovation adopters. Accordingly, they do not have skills to evaluate and manage innovation risk like Kamal. So the chance of an individual adopting the wrong innovation is high and such a decision would have a detrimental impact on their career. This avoidance of risk, protects the organisation in the short term from bad decisions, however in the long term, it limits the organisation’s operational growth and productivity.
It also reduces the demand for R&D in our society.
R&D policy cannot ignore the basic economic law of supply and demand. If governments want to increase the level of R&D in a their country, stimulating the supply side is insufficient. Sure it may increase the amount of R&D in the short term but if companies cannot find buyers for the output of R&D, then the increase will have low additionality and not be sustainable without the subsidies. Without corresponding demand, stimulating supply leads to overproduction, which never works in the long term.
The government could directly create some demand itself by funding organisations that purchase innovation, such as Defence or companies in favourite industries. They could also generate demand by assisting to companies to find overseas customers. However neither of these approaches are unlikely to scale commercialisation of R&D in Australia. The best solution is to create independent local demand for the output from R&D.
I believe the solution is to have Australian organisations become more adept at adopting innovation. They need more people with skills like Kamal’s:
So in effect, the solution requires changing: people’s behaviour, management approaches and organisational culture.
A challenging task! Something I will further explore in a subsequent article.
In Australia only 2% of companies actively engage in the development of new and novel innovations: Productivity Commission 2023, 5-year Productivity Inquiry: Innovation for the 98% ↩
How important is business R&D for economic growth and should the government subsidise it? ↩