The Third Answer:
How Market-Creating Innovation Drives Economic Growth and Development

By: , , and

January 7, 2019

Originally published by MIT Press in Innovations: Technology, Governance, Globalization as part of a special issue on “Blockchain for Global Development.” 

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Two schools of thought have dominated the theory of economic growth over the past half-century. The first and predominant philosophy—associated with Paul Romer, corecipient of the 2019 Nobel Prize in economics, and others—holds that ideas drive economic growth. Because ideas, once produced, can be copied and shared with minimal cost (so the story goes), they can fuel sustained economic growth in ways that are not possible for other factors of production.

The second school of thought acknowledges that ideas may be the seeds of growth but points out that such seeds cannot, and will not, grow in poor soil. The most fertile soil for growth is quality institutions—the lack of which is the ultimate limiting factor in most places. Institutions refers to a nation’s “soft” infrastructure and includes entities that make up the financial, judicial, legal, political, and even some social systems. Institutions can be formal (nation-states, schools, hospitals) or informal (practices and structures of authority that derive from custom and culture rather than laws and policies). This line of argument has been so persuasive that some international organizations, such as the United Nations and the World Bank, collectively spend billions of dollars trying to help people in poor countries develop new institutions or fix existing ones.

Both of these perspectives have evident merit—indeed, they are historically linked. Economies expanded at a snail’s pace globally until the 18th-century Age of Enlightenment, when the simultaneous emergence of scientific methods and procedures of modern democracy propelled humanity into an era of learning and discovery far beyond any previously known.

So, which is it—do ideas or institutions fundamentally drive long-term economic growth? In this essay, we propose that the most historically accurate and practically useful answer to this question is, in fact, neither. In the place of these two conjectured fundamental drivers of long-term economic growth we propose a third: market-creating innovation.

What supports this assertion? First, ideas result in economic growth and development only when they are realized through market-creating innovation. (We explain below why we emphasize “market-creating” innovation). The actual process of market-creating innovation is nothing like the zero-cost transfer of ideas—knowledge spillovers—that are the centerpiece of ideas-based theories of economic growth. Market-creating innovation is costly and difficult. It involves highly specialized and skilled agents working over extended periods of time.

Furthermore, contrary to expert consensus but consistent with history, market-creating innovation drives institutional growth, not the other way around. Institutions represent the adaptive response of human communities to changes in the environment. For example, in every city in the world we observe a complex set of institutions designed to handle traffic—traffic-management systems (stoplights, railway crossings), urban planning (crosswalks, overpasses), a legal apparatus to enforce traffic laws, and so forth. However, these institutions clearly did not create urban traffic; the traffic came first, and human communities had to come up with ways to deal with it. But what created the traffic? Market-creating innovation—in our time, the revolution in transport brought about by automobiles and motorcycles. This example generalizes broadly.

In very different ways, ideas-based and institution-based theories of economic development both fail to account adequately for the central role of market-creating innovation and its close relative, individual agency. Individual agency and innovation bring ideas into economic practice and in so doing they shape the evolution of institutions.

In this essay, we begin by offering a definition and two examples of market-creating innovation that provide a foundation for the historically informed theory that follows. With this definition and the examples in mind, we next assess the two dominant theories of development— essentially, the currently dominant answers to the centuries-old question of why some countries prosper while others do not. Building on this, we assess how new influences such as Blockchain technology and emerging business models relate to market-creating innovation, institutional evolution, and, ultimately, economic development. We offer specific examples of how Blockchain technology is being deployed to support market-creating innovation. We conclude by considering how a better understanding of the drivers of development prompts us to reconsider the definition of development itself.

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Clayton Christensen is the Kim B. Clark Professor of Business Administration at the Harvard Business School and is the architect of Disruptive Innovation. Clay was named the World’s Most Influential Business Management Thinker in 2011 and 2013.

Efosa Ojomo is a senior research fellow at the Christensen Institute, and co-author of The Prosperity Paradox: How Innovation Can Lift Nations Out of Poverty. Efosa’s work focuses on using Disruptive Innovation theory to fundamentally change the discourse in the global development community, thus enabling nations to engender their own path to long-term growth and prosperity.