Firms in the capitalist economy are subject to the growth imperative. If they do not grow, they face inevitable extinction.

Intuitively, the economy is expanding, and a firm that is not growing in tandem with the economy is losing a share of the market. Given the winner-takes-all dynamics in many industries, a firm that is losing its market share will eventually cease to exist as an independent entity.

This is just one of the possible explanations. There are many others that are equally, if not more, convincing [1] [2].

How can a firm achieve sustainable growth?

To answer this question, we need a theory of growth, a model that describes how growth is influenced by various parameters. For the purposes of this discussion, we will be using a simplified version of the Solow model [3]. Consider the graph below.

Here K is the firm’s capital, which includes human capital, offices, computers, cloud services, knowledge, experience, and everything else that the firm uses to generate output Y. The firm invests a certain share S of its output to acquire and maintain capital. The rest is distributed to the shareholders. Capital is depreciating at a certain rate d. The function F relating capital K to the firm’s output Y is called the production function:

Y = F(K)

The Solow model predicts that the firm stops growing when the level of capital depreciation is equal to the level of investment. This is a point of stable equilibrium. For any given investment rate S, if K is less than K*, the firm’s capital grows to reach K*. If K is greater than K*, the capital drops down to K* due to excessive depreciation.

At the point of equilibrium, there are only two ways to restart growth: increase the efficiency of the production function F or increase the rate of investment S.

By increasing efficiency, we can create a new function F’ such that

F’(K) = A*F(K) = A*Y

where A > 1. Efficiency can be increased by raising employee productivity, deploying a new technology platform, optimizing the supply chain, etc.

Unfortunately, this strategy can only get us so far. The firm will eventually exhaust its addressable market capacity, and the growth of output Y will stop.

Growth in earnings can still be generated by “doing more with less”:

Y = F(K) = A*F(K/A)

This is the stage where the firm’s employees begin heading for the exits, voluntarily or otherwise, a process that cannot continue forever for obvious reasons.

Therefore, we conclude that the firm must eventually increase the rate of investment in its capital to maintain growth.

The trick is in finding investments with the marginal product of capital that is greater than the rate of depreciation:

F(K+1) – F(K) > d

This can usually be achieved by creating new products, acquiring new competencies, and entering new markets, that is, performing activities that are commonly known as innovation.

If this recommendation is so obvious, why are so few companies following it? Many firms get stuck at their points of capital equilibrium [4].

Our human nature is likely responsible for this seemingly irrational behavior.

Note that a positive outcome of increasing the rate of investment is not guaranteed. In fact, the opposite is true. A new product is more likely to fail than succeed, and several products must be launched before one that gains traction. Innovation is inherently risky.

Thanks to Amos Tversky and Daniel Kahneman [5], we know that most humans exhibit the “loss aversion” bias. We readily take risks to preserve the status quo and usually avoid taking risks that promise uncertain gains. There are many amusing experiments and parlor tricks that confirm the fact.

In practical terms, this means that at the point of equilibrium, the majority of the firm’s managers, including many members of its management board, would rather take the risk of killing a new product idea than assume the risk of supporting it. This behavior may be irrational but is entirely predictable.

Microsoft, for instance, one of the industry’s top innovators, was stuck in the Windows-Office equilibrium for a long time and entirely missed several key technology waves: search, social, and mobile. It took Satya’s courage and vision to eventually deprioritize Windows and embrace cloud computing.

Fortunately, there may be a solution to the “loss aversion” bias problem in the financial services industry.

Equity traders notoriously suffer from their own flavor of “loss aversion.” They often take the risk of holding on to declining equities for too long, hoping that the equities will recover and save them from the pain of embarrassment. There are spectacular instances of traders losing billions of dollars in this fashion [6].

Educating people about the “loss aversion” bias does not help. The instinct is buried deep in our animal brains. The prefrontal cortex is often powerless to control it.

The solution that the investment management industry came up with is called systematic trading. According to Wikipedia, “Systematic trading (also known as mechanical trading) is a way of defining trade goals, risk controls and rules that can make investment and trading decisions in a methodical way. Systematic trading includes both manual trading of systems, and full or partial automation using computers.”

Similarly, systematic innovation, a way of making methodical capital investment decisions, can provide an escape route from the capital equilibrium trap.

Systematic innovation is a methodology that defines goals, risk controls, and rules in at least three areas:

  • People. How is the firm organized to facilitate innovation? How is performance measured and rewarded? How is talent acquired and retained?
  • Processes. What are the processes for sourcing and validating innovative ideas, funding projects with uncertain outcomes, and managing a portfolio of such projects?
  • Technology. How are the innovation goals, risk controls, and rules reflected in the information systems, collaboration platforms, and analytical solutions used by the firm?

The idea is definitely in the air. There is a growing realization among business leaders that innovation is vitally important and must be actively managed. As a reflection of this interest, Gartner recently placed “Innovation Management” on the upward slope in the Hype Cycle for Enterprise Architecture [7].

In summary, the innovation imperative is a direct corollary of the growth imperative. Firms must either grow or die. Sustainable growth is impossible without innovation. Due to ingrained behavioral biases, innovation cannot emerge organically in a mature organization. It must be proactively incentivized and actively managed in a methodical way that we call systematic innovation.

References

  1. M. Gordon and J. Rosenthal, "Capitalism’s Growth Imperative," Cambridge Journal of Economics, p. 25–48, January 2003.
  2. M. Binswanger, "Is there a growth imperative in capitalist economies? a circular flow perspective," Journal of Post Keynesian Economics , vol. 31, no. 4, 2009.
  3. N. G. Mankiw, Macroeconomics, New York: Worth Publishers, 2016.
  4. C. M. Christensen, Innovator's Dilemma, Cambridge: Harvard Business Review Press, 2016.
  5. A. Tversky and D. Kahneman, "Judgment under Uncertainty: Heuristics and Biases," Science, vol. 185, no. 4157, pp. 1124-1131, 1974.
  6. A. W. Lo, Adaptive Markets: Financial Evolution at the Speed of Thought, Princeton University Press, 2019.
  7. P. Allega, "Hype Cycle for Enterprise Architecture, 2020," Gartner, 2020.