Anne Truitt Zelenka

How does economics model entrepreneurialism? What implications does this have for Web 2.0 startups? And where might we expect to see the next wave of innovation in the creation and use of online services? Perhaps we ought to look at the nonprofit and NGO community for radical breakthroughs in the use of Web technology.

The current edition of The Economist discusses the economics of entrepreneurialism, noting that standard microeconomic theory describing interactions among firms in a market doesn’t account for entrepreneurs’ innovations:

Microeconomics instead gives pride of place to prices. Guided by the wages and interest rates they must pay, businessmen choose among different techniques of production (labour-intensive when workers are cheap, capital-intensive when they are scarce) but they do not reinvent or revolutionise them. Guided by the price their wares will fetch, they decide to make more goods or fewer. But they do not conjure up new products that no one had previously thought of.

William Baumol, an economist with positions at Princeton and NYU, follows in Joseph Schumpeter’s path by focusing not on how pricing adjustments lead to supply and demand equilibria but rather on the innovative goods and techniques that can destroy established companies. The Schumpeterian vision of economic growth driven by creatively destructive entrepreneurialism is much more exciting than the stationary equilibrium defined by standard microeconomic theory. For those of you who have studied the history and philosophy of science, the supply and demand equilibria achieved by pricing changes and improvements to existing technologies are akin to normal science that incrementally improves existing theories. Schumpeter’s entrepreneur brings forth paradigm shifts in the market just like those that occur in Kuhnian scientific revolutions.

According to The Economist, Baumol distinguishes between incremental improvements and radical innovations:

Most innovations are merely incremental improvements on something that already exists: a slightly better mousetrap, as Mr Baumol puts it. A rare few represent discontinuous breakthroughs, such as the incandescent lamp, alternating electric current or the jet engine. All of the above, according to Frederic Scherer, professor emeritus at Harvard, were introduced not by the regimented R&D of established corporations, but by scrappy new firms, twin-born with the invention itself. Mr Baumol ventures that most breakthroughs arise this way—the offspring of independent minds not incumbent companies. He has two explanations for this. First, radical innovation is the only kind lone entrepreneurs can do; and, second, they are the only ones who want to do it.

Let’s take Baumol’s two suggestions in order. First, “radical innovation is the only kind lone entrepreneurs can do.” The idea here is that lone entrepreneurs (with whom I will lump in small startups with few employees), with their limited resources, can only produce the simplest of goods or services; Baumol compares building the Kitty Hawk to upgrading the Boeing 737 to the 747. Individuals or very small firms can build something entirely new but will find it difficult if not impossible to augment something that already exists in mature form in the marketplace. If true, this implies that many Web 2.0 startups will have a rough road, as many appear to be offering incremental improvements over existing services and apps rather than truly innovative online capabilities.

Consider the case of Writely, recently acquired by Google, a company that produced an online, collaborative word processor. Writely did not make any attempt to match Microsoft Word feature for feature; their service is not comparable to MS Word or any other feature-rich desktop word processor. Had they set out to beat MS Word via feature checklist, they would surely have failed. [Thanks to the RedMonk guys for their podcast that discusses Google’s acquisition of Writely in depth.]

Second, Baumol suggests that only lone entrepreneurs want to do radical innovation. Why? Because it’s so risky that only crazy and obsessed people, not button-downed big-company managers, will want to do it. This echoes what Paul Graham said about finding recruits for a startup:

One of the best tricks I learned during our startup was a rule for deciding who to hire. Could you describe the person as an animal? It might be hard to translate that into another language, but I think everyone in the US knows what it means. It means someone who takes their work a little too seriously; someone who does what they do so well that they pass right through professional and cross over into obsessive.

If Baumol is right, then radical innovations are only going to come from people doing their work for love and not money, because the risk-reward ratio is not on their side. The Economist cites a survey of 1,091 Canadian inventions. Only 75 of these innovations reached the market, and 45 of those lost money.

The new head of MIT’s media lab, Frank Moss, echoes Baumol in an interview with Business Week when he offers advice to would-be entrepreneurs:

Resist the current temptation to make incremental changes to attract funding. It might get you off the ground, but I don’t think it will get you very far. Today, the funding climate has changed. The successful (entrepreneurs) will look for fundamental disruptive change. I encourage them to take risks, rather than just polish the faucets. There will always be an appetite for game-changing technology.

Moss suggests where risk-lovers might look for opportunity:

Companies are now paying attention to some of the major socioeconomic problems in the First and the Third World. We have a billion people using computers in the First World. It is still limited to wealthier societies.

In the next 20 years we will see the adoption (increase) to 5 billion to 6 billion. And the kinds of killer apps that are important in that world are not those necessarily centered on communication and commerce.

I think as we experience the problem of aging populations we will need to supply different ways to educate, and traditional schools are not the way to go. We will see technology dramatically change the way kids learn. We will see health care without hospitals. That is where the action will be. Just another tweak to a telephone or a handheld device will happen, but it will not be a major source of growth. That is becoming a commodity.

I’m wondering if some of the next great Web innovations will not come from me-too Web 2.0 startups building feed reader or to do list or Ajax start pages, but rather from organizations and individuals with a bent towards solving social problems. Adam Green noted how librarians are pushing technological innovation. I see the same hunger for new technology and radical ways of deploying it within the nonprofit and NGO community, as with organizations like NetSquared. That’s a domain where you’ll find people with a sense of mission about what they do, with little regard for financial reward, and with many opportunities to make a difference using simple but radically innovative approaches. I mentioned in my last post that I want to expand my thinking beyond individually-oriented social media to enterprise-level problems. I also want to take a global and philanthropic view of what Web technology can do. Though I’m more a writer than a doer, I hope that what I highlight and promote and write about might be a small piece of the solution to the socioeconomic problems the world faces today. That’s where I think and hope the next round of online innovation will happen.