• New research from Ramesh Rao of The University of Texas at Austin challenges traditional economic theory.
• Do markets or firms do innovation and wealth creation best?
• And what might the answer mean for further research, and the world?

The twenty first century has been a volatile period for theories of value. Norms have been stripped in the face of the demands of the market. Patriotism used to matter. To the Quakers, duty to workers mattered. For years, attitude to church mattered. Now, we praise and fear and advise the market, much like a toddler that is also king. In the recent past, social concerns have returned, albeit in a smaller way, and ESG has come to be important in measuring the performance of a company.

But are we looking in all the wrong places when it comes to value? Who really generates wealth – markets, or, in fact, firms?

Traditional economic theory would have you believe that markets are the primary drivers of wealth and innovation. New research says otherwise, overturning centuries of accepted economic shorthand.

Or so says Professor Ramesh Rao, director of the Wealth Management program at The University of Texas at Austin’s McCombs School of Business, in a new, dogma-smashing theory. His work argues that traditional value theory is blind to the realities of the world.

The crucial role of firms in wealth creation

Going back to Adam Smith and Milton Friedman, founding thinkers of contemporary economic theory, Rao’s paper reveals a new and surprising finding that challenges the traditional dominance of market-based models and underscores the crucial role firms play in wealth creation.

In fact, he concludes, firms can generate more wealth from innovations than markets.

“While proponents of free markets often cite Adam Smith’s “Invisible Hand” as a guarantee of optimality, our framework reveals a more nuanced reality”, he writes. Rao models differently, and delves into the interactions between innovation, competition, institutions, and organisations.

His argument is tripartite:

• Firstly, he argues that complete markets, in which all conceivable goods are already available do not exist.
• Secondly, he argues that there is always space for innovation, and that value creation patently exists.
• Thirdly, he argues that it takes time for goods to move, for “real-world economic activity” to occur. In traditional theory, all desired goods are instantaneously exchanged in markets, leaving no room for non-traded agreements that was exchanged at different times than when the agreement was made. These contracts permeate real, everyday life, from securing labor with deferred wages to taking out a loan that is to be repaid at a future date. These exchanges are based on trust. Trust, however, has no place in standard value theory.

The frictions that are inherent to real life make the ideal of complete markets prohibitively expensive.

Rao finds that “mutually beneficial contracts at market prices may not always be attainable, casting doubt on the universality of Smith’s claim.” He argues that it is time to recognise the role of transaction costs play in shaping the economic outcomes we live with, and it is also time to start to recognise that innovation generates new wealth.

His study identifies a key challenge to traditional market-driven thinking about innovation: uninsurable risks associated with new ideas.

Reducing uninsurable risks

The uncertainty around an innovation’s success before launch, or the negative potential of unreliable entrepreneurs, leads suppliers of production inputs (labor, materials) to demand higher prices to compensate. This makes potentially unviable or even marginally viable innovations commercially unattractive in a market-only setting, producing a deathly muffling of innovation.

Unlike markets, firms can leverage their financial resources and established structures to mitigate these risks. They can coddle some failure of innovation as they have reserves and robust legal structures allow firms to absorb potential production shortfalls and guarantee payments to suppliers even if the innovation fails. They also have a risk appetite and are willing to front innovation to potentially reap the large rewards of successful innovation.

A firm’s status as established firm also reduces suppliers’ concerns about untrustworthy entrepreneurs, making production inputs cheaper, and innovation projects more attractive.

By mitigating uninsurable risks, firms create an environment where even marginally viable innovations can thrive. This unlocks a wider range of ideas, fostering a more diverse innovation landscape that benefits inventors, investors, consumers, and, in turn, society.

“Not all innovations are economically viable when production is organised through the markets,” says Professor Rao. “This is because the suppliers of factors of production will demand market prices that reflect the innovation’s potential for failure and for the propensity of entrepreneurs to act opportunistically. Firms can create extra value by absorbing these risks and making innovative ideas cheaper to implement.”

In fact, firm production can provide better results when compared to market transactions, which “underscores the critical role of firms in nurturing innovations and unlocking their full potential for economic growth.” This is not to say that firms are simple. Even within firms, there is a “complex interplay between contracts, institutions, and wealth creation.”

Encouraging innovation and long term prosperity

Rao’s work has significant ramifications for policymakers. It shows them policymakers seeking to encourage innovation and long-term prosperity should not only focus on markets, but also create an environment conducive to the formation and efficient functioning of firms. These include but are not limited to:

• Fostering robust legal institutions.
• Facilitating and cutting red tape around firm creation.
• Supporting entrepreneurial ventures.
• Strengthening property rights infrastructure.
• Promoting and improving access to credit for firms and entrepreneurs.
• Addressing challenges associated with uninsurable risks.
• Investing in education and skills development to encourage and sustain a vibrant entrepreneurial ecosystem.

Researchers and policymakers can use this radical new research to foster and encourage fresh and innovative economic growth and development.

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