The Nobel Prize committee’s message for European innovation

This year’s Nobel Prize in Economics, awarded 13 October, contains a timely and critical message to European Union policymakers: accept and embrace the creative destruction that is a necessary consequence of successful growth and innovation. This message comes at a moment when major changes to EU innovation policies are being debated, including implementation of the September 2024 Draghi Report (written by former Italian prime minister Mario Draghi at the request of the European Commission to steer competitiveness policy), revision of the Merger Guidelines and the adoption of the EU Startup and Scaleup Strategy to encourage innovative companies.

Economic historian Joel Mokyr won the Nobel Prize for his work illuminating how different kinds of knowledge generate new ideas, products, methods and technologies that satisfy human needs. The other two winners, Philippe Aghion (formerly a Bruegel Non-resident Senior Fellow) and Peter Howitt, won for their formal modelling of innovation and R&D.

In particular, Aghion and Howitt modelled the incentives firms have to engage in R&D, discover new knowledge and turn that knowledge into profitable products and services. Importantly, such firms realise that their successful new products will not last forever, and eventually they will lose customers to challengers with better ideas. This threat of loss both disincentivises the firm from innovating (because it cannot capture the returns forever) and incentivises it to keep innovating (to win again against its competitors). Combine these incentives with other R&D spillovers to consumers and society, and the innovation setting becomes complex. The researchers built a macro model in which they solve for equilibrium investments in R&D and generate rich policy implications.

The policy implications emphasised by the Nobel committee are critical to the current debate in Europe. These scholars all study creative destruction – the intuitive concept that new ideas and business often replace, or destroy, old ones. When mobile phones came along, consumers bought fewer fixed-line phones; electric cars are likely to displace petrol cars, and so forth.

Thus, in the world of business, formerly successful firms will lose sales and be displaced by challengers with better ideas or better products. When this happens, policymakers see well-established, familiar firms with good connections and many workers facing hard times. Their instinct is to protect such firms, which can be costly. But the work of the Nobel Prize winners teaches us not to protect a particular corporation, but to embrace destruction when it is caused by valuable innovation elsewhere. The failure or decline of old businesses allows resources to be redeployed to their highest value uses. Society gains from new ideas that benefit all.

Fundamental values require governments to look after those workers who are harmed by the process of creative destruction. But this does not require protecting their jobs (in fixed-line phones or petrol cars, for example) but instead protecting the people themselves through support and training, equipping them to find work in growing sectors. For the same reason that protecting a particular corporation lowers growth, so does protecting particular jobs. Regulations in Europe, most famously labour policies, prohibit or slow reallocation, limit creative destruction and thereby lower incomes. 

The Nobel committee also emphasised a second point: the laureates’ research demonstrates that too much market power depresses innovation and growth. A monopolist does not fear losing its customers to a rival with a better idea or product and therefore feels no need to spend on innovation. When concentration becomes too prevalent in an economy, innovation and dynamism fall.

Aghion and Howitt posit that large firms, such as the biggest digital platforms, have operated with significant market power for two decades. Their concern is that market power – not only in digital, but across the economy – may cause less creative destruction and, therefore, low growth and insufficient innovation. More competition holds the key to more innovation.

What can EU policymakers learn from this year’s prize? Vigorous merger guidelines and antitrust enforcement that protect disruptive competitors are critical to support innovation in the EU. Finding ways for startups to become established and grow quickly across the EU is of paramount importance to growth. And measures to follow through on Draghi’s recommendations on increasing innovation need to build in an appreciation that the resultant new growth must be allowed to cause creative destruction and that workers must therefore be protected appropriately.