The Challenge

Abstract

During recent years, challenges have emerged on an unprecedented scale, affecting nearly all the countries of the globe: climate change, energy supply, geopolitical tensions, protectionist measures, demographic changes, and a seemingly infinite demand for human capital, to mention but a few. Until recently, the most compelling challenge seemed to be increased globalization and intensified competition at all stages of the value chain. This threatened the privileged position of industrialized economies and their businesses, prompting measures to enhance efficiency and competitiveness at both the policy and firm levels. Even though the world economy currently seems to be in a phase of decoupling, deglobalization, and increased state intervention, we believe that in the medium to long term, the global economy will continue to embrace openness. Hence, fortune favors the well-prepared, and both countries and businesses are likely to benefit by positioning themselves for a return to the prospect of increasingly competitive markets.

During recent years, challenges have emerged on an unprecedented scale, affecting nearly all countries of the globe: climate change, energy supply, geopolitical tensions, protectionist measures, demographic changes, and a seemingly infinite demand for human capital, to mention but a few. Until recently, the most compelling challenge seemed to be increased globalization and intensified competition at all stages of the value chain. This threatened the privileged position of industrialized economies and their businesses, prompting measures to enhance efficiency and competitiveness at both the policy and firm levels, while, at the same time, creating opportunities for developing countries. Even though the world economy currently seems to be in a phase of decoupling, deglobalization, and increased state intervention, we believe that in the medium to long term, the global economy will continue to embrace openness. Hence, fortune favors the well-prepared, and both countries and businesses are likely to benefit by positioning themselves for a return to the prospect of increasingly competitive markets.

Coming to grips with the present challenges requires well-reasoned and substantiated policies, and here, innovation is a key factor. To express the matter differently, creative and fresh thinking will help develop policies that incentivize individuals and businesses to envision new products, services, and business models. Such creativity and innovation will also help transform these ideas into dynamic businesses that will succeed in attaining a size at which significant economies of scale can be realized. This requires entrepreneurship.

Our point of departure will be our native country, Sweden, which experienced dwindling growth rates and lackluster industrial dynamism between the 1970s and the mid-1990s. The country managed to realize an impressive economic turnaround through an ambitious reform package implemented in the aftermath of the deep economic crisis of 1991–1994. The first reform wave strengthened the macroeconomic side of the economy by making the country more resilient in the face of financial and debt crises. Subsequent reforms had a more microeconomic profile by targeting areas decisive for essential creative destruction processes, notably taxation, social security, entrepreneurship, labor markets, innovation, and venture capital. More recently, new problems have emerged that need to be solved. Unemployment, particularly among the young, remains at a high level; an aging population puts pressure on the welfare state; certain key competencies are in short supply; uniquely rapid net immigration has caused massive integration problems; educational standards have deteriorated; and the judicial system is increasingly troubled and overburdened—phenomena that fuel populist tendencies in the political landscape. Yet, we believe that there are lessons to be learned from the turnaround of the Swedish economy which provide valuable insights for other economies as well.

Economies need to be equipped with adequate instruments to cope with these current challenges. In fact, economic growth is a prerequisite for resolving many of these issues. But growth in the sense of “more of the same” is not the solution. Increased production with current technology would exacerbate environmental problems. The export sector will rapidly become obsolete if it continues to manufacture the same products it always has. In sectors such as education and health and social care, quality is more important than volume. Continued renewal and transformation of the economy are therefore the keys to prosperity and sustainable growth. New technology, new knowledge, new working methods, and new organizational forms are needed to make economies competitive, lower the thresholds to the labor market, create new resources and further prosperity without compromising the environment. In other words, the dynamics of the business sector must be strengthened, with a particular focus on the conditions for innovation.

Innovation does not simply concern new high-tech goods, but rather all manner of changes—in production methods and organizational forms—which ultimately lead to increased value for society. Such innovations require carriers; entrepreneurs who drive change, confront tradition, and experiment with new ideas are essential in this respect. They can be lone wolves or work in teams; they can serve as the engine for large projects; they can be small business owners or enthusiastic intrapreneurs who renew and improve the functioning of incumbent firms; and they can work in the private or public sector. Entrepreneurs are driven by different goals: some are passionate about an idea, some want to launch a new product, some wish for financial gains and still others may be entrepreneurs by necessity in a tough labor market where they cannot find permanent employment.

Economists distinguish between different kinds of innovations: process innovations (which improve the production process) and product innovations (which lead to new products), as well as between gradual improvements (incremental innovation) and radically and disruptive new products and services. Our purpose here is not to delve into the taxonomy of innovation, but rather to discuss how innovation activities in general can be stimulated and how a policy for innovation in the broadest sense should be formulated. The task is obviously not simple. By definition, innovations concern the creation of something new. This means moving past old and established patterns, exercising creativity, and breaking with tradition, activities often attributed to the entrepreneur. Mapping the factors that promote such creativity is complex. It is even more difficult to formulate a policy that makes new ways of thinking easier and more widespread; in a certain sense, we are seeking to create a “routine” for something that is, de facto, about the very breaking of routines.

We maintain that the policy debate on innovation is often too narrow. It tends to concentrate on research and development, R&D, for the development of new, high-tech products and how these products can be successfully marketed. Therefore, policy recommendations are often about how support for R&D should be organized and financed, and how to raise capital in the early stages of the life cycle of a business. In the political debate, the question is often formulated in terms of how to boost skills and then turn them into new high-tech products.

These measures are important, but far from sufficient—a broader approach is required. Innovation is about significantly more than creating the knowledge to develop new products. Innovation can also mean that existing knowledge is diffused throughout an economy and used in new areas, new organizations, and in new ways. To support innovation in this broad sense, policies must create structures that facilitate the dissemination of knowledge and promote entrepreneurship in both large and small organizations. The goal is not only to develop new breakthrough products with a high technology content, but also to stimulate many small steps in the improvement of “ordinary” products and services, regardless of their technology content, and to make organizational forms and production processes more efficient throughout the economy.

Neither the creation of new knowledge nor its application takes place in isolation, i.e., exogenously, nor does it automatically benefit society. For this to happen, society as a whole—and not least of all economic policy—must value, support, promote, and stimulate knowledge accumulation, education, entrepreneurship, and competition. Our policy recommendations are therefore more comprehensive and all-embracing than is usually the case in discussions surrounding innovation and entrepreneurship. They cannot be limited to simple volume targets for R&D investment or the supply of early-stage financing. They must extend much further.

We therefore argue that innovation policy rests on two pillars:

• 1. Building and strengthening the knowledge base and

• 2. Creating conditions for the dissemination, application, and commercialization of knowledge

The purpose of this book is to describe this approach and identify which policy tools can and should be used to stimulate innovation in this broad sense. We believe that systemic weaknesses must first and foremost be remedied by an innovation policy that promotes continued renewal by strengthening incentives for experimentation, innovation, and entrepreneurship. In this respect, our proposal differs from the traditional “innovation system” approach, which is more focused on the structure of innovation than on the forces that drive it.

This introductory chapter explores some of the challenges outlined above and explains why innovations are so important for Western welfare societies, using Sweden as an example. Chapter 2 describes the dominant theoretical growth models and the model that we advocate, while Chap. 3 provides a general overview of the conditions for entrepreneurship. In Chaps. 4 and 5, we present a detailed analysis of the conditions in which Swedish entrepreneurship is embedded. This analysis then provides the basis for our policy recommendations. These are generalized and summarized in the form of an innovation policy framework in Chap. 6—in other words, in clear rules to be used in policymaking.

1.1 The Swedish Example

Since the mid-1990s, Sweden has enjoyed quite positive economic development, both compared to most small countries with similar conditions and to itself during the two preceding decades. Up until the 2008–2009 financial crisis, the Swedish economy had grown more rapidly than the economies of both the United States and Europe. Nevertheless, between 2010 and 2021, the United States has grown at a faster pace whereas Swedish growth is essentially on a par with the EU average. At the same time, the domestic financial situation has become significantly more robust due to the reforms implemented in the 1990s, and Sweden has shown healthy surpluses in the current account and the public sector, while at the same time having a stronger banking system. For several years, in fact, Sweden has enjoyed one of the strongest financial positions within the EU and has also been far more resilient to crises, as clearly manifested during both the IT and financial market crises as well as during the pandemic.

There are several reasons for this positive turn in the Swedish economy. Most important is arguably the deep crisis of the early 1990s, which eliminated the least productive parts of industry and sparked a series of structural reforms that marked a radical break with much of the economic policy of the 1970s and 1980s. Stricter budget rules, tax reform, deregulation, stricter competition legislation, EU membership, an independent central bank with inflation targets, a floating exchange rate, and pension reform—within a mere few years’ time, radical economic policies came into effect. The new frameworks established for monetary policy (inflation targets with guidelines for interest-rate setting) and fiscal policy (notably surplus targets and expenditure ceilings) were particularly important. At the same time, Sweden was—at least in the short term—helped by a weaker currency, strong growth in the global economy, and favorable positioning regarding new information technology. Both government expenditure and taxes as a share of GDP have declined since then, and in recent years, tax rates on labor have been significantly lowered.¹

Due to the far-reaching reform agenda successively implemented since the mid-1990s, Sweden was able to cope with the ensuing crises from a position of strength. Today Sweden has significantly better financial buffers than virtually all other European countries. The Swedish economy has also climbed in international rankings of competitiveness, attractiveness to business and innovativeness—characteristics that are important for the maintenance of a strong position in the globalized world economy. However, to sustain such a position requires continual policy reforms adapted to the ever-changing circumstances in the global economy, and here we fear that Sweden is losing ground even though the state of affairs is still strong, see Table 1.1.

Table 1.1 Country ranking according to the five most common measures of national innovativeness, top 20 countries for the latest available year

The rankings in this table depict the top 20 countries according to the most commonly used measures of competitiveness and innovativeness. Sweden is ranked number one among EU countries in three of the five measures. Switzerland, a small open economy albeit not part of the EU, is also ranked highly according to all five measures. The Asian powerhouses Singapore and Hong Kong are at or near the top based on several measures. Nonetheless, half of the top 20 countries in all rankings are European Union members; in particular, the Nordic and Western European countries continue to do well. By contrast, southern and eastern EU member states are absent in the rankings, which bears witness to Europe’s well-known core/periphery pattern. Thus, the EU’s alleged “innovation emergency” (European Commission 2015) is far from uniform, and if this stark inequality is allowed to persist, it is likely to result in increased tension between countries and regions within the Union. Currently, internal tensions within the EU risk being aggravated by its larger members calling for more interventionistic industrial policies and more generous possibilities to use state aid and subsidies granted at the EU level. That is likely to favor the larger and northern EU countries. Hence, a lessening of these tensions and a strengthening of innovativeness in countries and regions that are experiencing less economic success cannot be achieved without an improved understanding of what policies and framework conditions are necessary for innovation and commercialization.

The fact that Sweden has done so well in the aftermath of the 1990s crisis is partly due to the reforms that paved the way for continued structural transformation during subsequent decades, and partly due to the fact that the specialization of Swedish industry happened to fit well with increased global demand (notably IT/telecom, machine tools, and pharmaceuticals). This has delivered export successes and boosted domestic purchasing power. The Swedish labor market has also succeeded relatively well in terms of rehiring or retraining workers who have been laid off without the government needing to provide extensive industrial subsidies or other public support programs, apart from the measures taken during the pandemic.

1.2 The Challenges Ahead

1.2.1 Globalization or Deglobalization?

In 2009, Sweden’s Globalization Council—an inter-ministerial unit working for the Swedish government—presented its concluding report on reforms required for Sweden to retain its position as an innovative knowledge economy.² The work was commenced in 2007, when globalization was at its peak. A large number of high-quality commissioned reports, conducted by renowned European and U.S. scholars, constituted the core of the analysis. The concluding report stressed microeconomic reforms to improve framework conditions for a dynamic, experimental, and innovative business sector. Such reforms would help in coping with both accelerating global competition for capital investments and the risk of a potential brain drain. Low-cost competition implied continued pressure on companies in which jobs could be moved abroad, while at the same time the competition for talent, entrepreneurs, technology, and investment from more mature industrialized countries was expected to intensify. Approximately 50% of the 118 policy recommendations in the concluding report had been instituted ten years later (Braunerhjelm 2020), roughly half of them fully and the rest partially.

Overall, the dip in global trade in 2008–2009 was viewed as a temporary phenomenon, and as the crisis diminished, a return to business as usual was expected. However, that did not occur. Instead, world trade levelled out and then began to decline (Fig. 1.1). This decline coincided with the United States entering a more protectionist phase during Donald Trump’s presidency, which was maintained by the Biden administration. National security concerns and the increasing role of digitization and digitized devices in surveying and generating information across borders have accelerated protectionism and led to the characterization of “strategic sectors.” This term reflects claims that such fields should be shielded from foreign ownership and influence. In addition, it involves export restrictions on goods and components considered strategically important. According to Global Trade Alert, protectionist interventions (both tariffs and other measures) have increased since 2008.³

Fig. 1.1

Trade (export plus import) as a share of GDP, 1980–2021 (%). Note: Data for the European Union include intra-EU trade. Source: OECD

To focus now on goods and services, the former has decreased whereas the opposite is true for the latter, even though service trade is more difficult to trace in the statistics. It has been argued that the falling trade in goods simply reflects lower global growth, which is associated with a few countries, especially China and the United States. Hence, the fall in trade from 61% of global GDP in 2008 to 56% in 2021 is claimed to mirror a move back to normal after the hyper-globalization of the mid-1980s through 2008.

On the other hand, rising incomes and a rapidly growing middle class in developing countries should boost the demand for imports and induce more trade. At the same time, technological advances, digitization, and (previously) increased globalization intensified competition and resulted in a fragmentation of supply chains. When economists previously spoke of “comparative advantages” in foreign trade, they typically referred to entire industries or countries. In recent decades, the meaning has shifted to specific tasks within an industry—even within a firm or within an individual department of that business: crucial tasks necessary to produce a final product could be performed on the other side of the globe as part of a fully integrated production system. The increased partitioning of the value chain risks being halted due to escalating trade barriers and geopolitical tensions. To reorganize production will take time. Companies are also urged or incentivized to resume production domestically or at least in countries that are geographically closer. Overall, the strong trend towards outsourcing has been stopped in the last few years and the development of the so-called kaleidoscopic comparative advantages has been stalled, at least temporarily.

Interestingly, even though trade in final goods has regressed to some extent, no similar pattern can be found for trade in intermediate goods. As Fig. 1.2 shows, trade in intermediate goods has grown rapidly following the sharp downturn caused by the onset of the pandemic in the first half of 2020. This suggests that production is still dependent on the supply of intermediate goods through global distribution channels.

Fig. 1.2

Trade in intermediate goods (excl. fuel) for the world and regionally, Q2 2019–Q4 2022 (2019 = 100). Source: WTO information note on trade in intermediate goods: fourth quarter 2022 (https://www.wto.org/english/res_e/statis_e/miwi_e/info_note_2022q4_e.pdf)

In the case of Sweden, which is still dependent on a relatively small number of large multinational firms (e.g., Ericsson, ABB, Atlas Copco, Sandvik, SKF, Hexagon, IKEA, and H&M), the intensification of international competition can have rapid and direct effects. Disturbances in the flow of intermediate products would be detrimental to these companies. Similarly, should some of these national “crown jewels” relocate production or lose their competitive edge, the ecosystems built around these firms, and therefore the Swedish economy, could experience significant negative impacts. The situation is exacerbated by the fact that over the last decades, the aggregate share of sales in the domestic market of Swedish multinational companies has decreased considerably. The same is true for foreign-owned companies with a high volume of manufacturing located in Sweden.

Hence, the decision about relocating manufacturing or R&D is not a particularly difficult one. Domestic companies so important to Sweden are being challenged by new competitors, increasingly so by businesses from China and India. The pattern of competition is changing rapidly, and the competitive advantages enjoyed by mature industrialized countries in advanced production have been challenged for some time.

To conclude, the benefits or disadvantages of globalization have not yet been assessed adequately. First, globalization takes several forms, and trade in goods is merely one aspect. Migration, foreign direct investment, and capital flows are other components of globalization that have arguably remained at the same level or even increased (Baldwin 2022; Dadush 2022). Hence, despite a possible slowdown in global exchanges, we argue that global competition can be expected to continue even though it may take on a different guise. Nations and businesses consequently need to prepare for continued competitive pressure and restructuring.

1.2.2 The Growing Service Sector and the Labor Market

The service sector is increasingly exposed to forces of competition, and this calls for capacities to adapt and restructure in order for companies to survive. Since the service sector has been shielded from competition to a greater extent than goods production, the potential for improvement tends to be greater. Sweden’s service sector is significantly larger than its goods-producing sector, and, on average, service sector productivity is lower. However, there are also highly productive service industries that are well-positioned to meet fiercer competition, especially in business-related services.

The service sector includes both private and public providers, sometimes operating on the so-called quasi-markets defined by a public agency acting as a link (in the capacity of client and/or financier) between customer and producer (Le Grand 2009). Among the latter are services such as education, health, and social care, which are in need of renewal, quality improvements, and greater efficiency in order to meet future challenges. These service sectors are central to a nation’s knowledge base, and, despite consuming considerable resources, they suffer from significant quality problems. Such problems in the educational system are particularly serious, as they are likely to induce path dependency leading to a deterioration in subsequent links of the nation’s knowledge base (Henrekson and Wennström 2022; Heller Sahlgren and Jordahl 2023).

As the population ages, it requires more of several different types of care, including healthcare, meal services, and cleaning. This means a demand for more resources—both in terms of hours worked and financial resources—and greater efficiency. In this area, demand is growing much faster than the aggregate economy; one reason for this is that technological advances in medicine and medical technology are creating the possibility of new treatment methods. Since it is generally more difficult to increase productivity in care services than in manufacturing, relative costs tend to increase in line with the so-called Baumol’s Cost Disease (Baumol 1967).⁴ Here too, innovation, especially organizational innovation, is required to increase quality and efficiency.

A better functioning service sector is also necessary to reduce unemployment and the exclusion of marginalized groups, thereby enabling more individuals to become self-sufficient. The service sector accounts for 75–80% of employment in most developed countries, and its employment share is expected to increase further in the future. If unemployment is to fall—not least among young people—more service jobs are needed. In manufacturing, most unqualified entry-level jobs have been phased out as starting wages have risen, and production processes have become increasingly mechanized, digitized, and sophisticated. Meanwhile, jobs requiring little training have been transferred to low-wage countries. The same is partly true in the service sector, where many simple jobs—which previously served as entry-level positions—have disappeared. This is the case although demand is high (not least of all in health and social care) and there are a plethora of basic tasks to be performed. Many service jobs simply cannot be outsourced; a nurse in Sweden, or for that matter a police officer, cannot perform their duties from Guangdong or Phnom Penh.

A growing problem in several developed countries, and particularly in Sweden, is the increasing share of working-age individuals (20–64 years old) who are not students, not self-sufficient, and dependent on social transfers. In Sweden, the estimated number of such individuals is about 1.4 million out of a working-age population of 5.6 million and a total population of ten million, of which roughly 700,000 are immigrants (Eklund and Larsson 2023). One reason is the incompatible combination of (previously) generous rules for immigration,⁵ a failing integration policy and a universal welfare state. At present, most European economies have introduced stricter immigration rules and made access to welfare services increasingly conditional. But the problems will linger for quite some time and at a considerable societal cost if integration policies continue to function poorly.

All in all, we believe that in order to create more entry-level jobs and stimulate competition and new forms of organization, there is a pressing need for a restructuring of service production and increased labor-market flexibility. The important point in this context is that innovation does not simply apply to the export industry or high-tech goods and services. Conversely, the service sector may benefit from experience gained in manufacturing, an area that has been exposed to competition for a considerably longer time.

1.3 Competition, Innovation, and Institutions

Some of the fundamental factors associated with the commercialization of inventions and the entry of new businesses in the market relate to a country’s openness, intellectual curiosity, and the rule of law—all necessary conditions for enabling entrepreneurial endeavors and innovations. Heterogeneity is crucial where different ideas and knowledge bases compete and experiment in the marketplace. Hence, discrimination—whether based on ethnicity, religion, age, or gender—is not only morally reprehensible but also economically inefficient, as it excludes potential entrepreneurs from exploiting opportunities and contributing to social advancement. Similarly, the capacity of an economy to develop depends not only on the organization and financing of the education system, how it equips future entrepreneurs, the flow of knowledge and entrepreneurs’ ability to modify or invent new processes and products, but also on how laws, regulations, taxes, fees, and subsidies affect entrepreneur behavior and motivation. Consequently, a society’s overall innovative capacity originates in a well-designed institutional framework where different policy areas are synchronized and interlaced in a manner that promotes competition and efficiently functioning markets.

Joseph Schumpeter—the Austrian economist who became the father of modern entrepreneurship theory through his 1934 book The Theory of Economic Development, first published in 1911—claimed that the entrepreneur was the central figure in “creative destruction,” the process by which the new incessantly drives out the old. However, towards the end of his scholarly career, he became increasingly convinced that innovation would be most efficiently conducted in rival large businesses. He believed that these companies had the skills and resources to drive new technology and new organizations. This thesis has been endlessly studied and debated, but the issue is far from settled. The current consensus is that innovation activities are most intense in a mixed environment in which medium-sized companies predominate, particularly if they reside in clusters and information-dense environments. Perfect competition among small businesses does not provide sufficient resources for expensive, high-tech research, while oligopolies and monopolies tend to become too rigid, focusing on measures to preserve the value of their current technology rather than sustaining their competitiveness by means of an innovation that risks making their current products and production methods obsolete.

Large firms have impressive R&D resources and should be able to exploit economies of scale, but technological development in recent decades also seems to be advantageous for smaller units. Whereas firms, particularly large ones, seem to be focusing on development rather than research, there is no aggregate discernible trend towards smaller firms undertaking a larger share of overall R&D (Becker et al. 2022). In some industries however, e.g., pharmaceuticals, smaller firms have increased their share of R&D (Anderson and Kindlon 2019). There are also indications that universities and research institutes are performing more research than previously (Arora et al. 2021). However, young, fast-growing firms contribute the most to growth and new employment. These firms are often referred to in the media as “gazelles,” even though there are industry-specific differences.⁶ A recent phenomenon among fast-growing firms is the emergence of platform companies; concerns have been raised regarding their long-term effect on competition and innovation.

1.3.1 The Emerging Platform Economy

Ongoing digitalization has implications for market structure and efficient functioning, not least when it comes to market entry and innovation. Essentially, it has profound implications for the organization of economic activity by altering supply chains, giving rise to new business models, and changing market structure.

On the consumer side, digitalization has doubtlessly yielded benefits in terms of improved accessibility, lower prices, or free products and services as well as increased variety paired with improved quality. The reverse side of this development is a strong concentration of market power in a small number of firms in several markets. This is due to the combination of low or non-existent marginal costs for an additional user/customer, huge network externalities and data that are monopolized by platform owners. Most of the concentrated markets can be found in the technology sector. According to Philippon (2019), almost all markets in the United States have experienced decreased dynamism due to faltering competition, which in turn stems from an aggressive use of non-compete clauses that compromise labor mobility, but also due to the emergence of platform companies. This has generated concerns regarding entry possibilities and future innovation.

Antitrust proceedings have also been initiated in the United States as well as in the European Union; this has been accompanied by a parallel updating of tools available in competition law. For instance, the Digital Markets Act (DMA) was introduced in the EU in 2022, the first comprehensive regulation of digital platforms aimed at improving the conditions for competition. In the United States, there is lively discussion on how to interpret existing competition laws given the way digitalization affects business behavior and market dynamism. The challenges facing competition policy have recently been addressed in a number of expert reports containing extensive discussions on how platform companies impact entrepreneurship and innovation (Mandorff and Nyberg 2023). This includes practices that affect bargaining power and potential abuse of dominant market positions, use of data, interoperability, and different modes of the so-called self-preferencing. In the United States, there is a clear shift in the interpretation and application of current competition laws in order to reduce the market power of platform firms.

1.4 Climate Change

Climate change, which arguably constitutes the most important challenge facing mankind, stems primarily from the emissions associated with burning fossil fuels (IPCC 2023). Currently, fossil fuel accounts for 80% of global energy production. To avoid detrimental environmental, social, and economic consequences, fossil fuel must be replaced by renewable energy. In the EU, a net zero emission target by the year 2045 has recently been prescribed by law.

Carbon pricing has long been favored by economists as the primary instrument to address climate change. This proposes that Pigouvian taxes be used to eliminate the difference between the marginal private and social costs of using fossil fuels (Pigou 1920). Through carbon pricing, the negative externality is internalized by the emitter. Yet, despite a strong theoretical basis for carbon pricing/taxes, the level of implementation, and the effects, of such instruments are still modest. A mere 22–24% of global emissions were covered by some kind of carbon pricing in 2021, in too many cases with questionable effects due to the low level of those taxes (Grubb et al. 2023).

More recent research has produced a more nuanced view of what is required to combat climate change. Specifically, this involves a simultaneous and rapid overhaul of the energy systems affecting a range of different technologies, industries, and ways of life, i.e., a more holistic approach (Braunerhjelm and Hepburn 2023). The energy transition also needs to be accomplished much faster than previous large-scale changes, which typically took roughly one century to fully unfold (Edquist and Henrekson 2006). Hence, technological change, innovation dynamics, and entrepreneurship can be expected to play a vital role in this transformation. In turn, this transition requires more extensive policies than those induced by an imposition of carbon taxes. In the last decades, the energy sector has also been characterized by innovation, resulting in falling costs for alternative energy sources.

1.5 Innovation Is Key

The list of challenges outlined above could be extended, but it is sufficient to illustrate that economies are facing complex problems including climate change, demography-related issues, competitiveness, digitalization, the labor market, and the welfare sector. If these are to be tackled successfully, extensive innovations are required, both large and small.

A common misconception is that an innovation is the same as an invention—typically created by a single ingenious inventor—which entails a new, preferably high-tech and revolutionary, industrial product. We still carry with us the images of Thomas Edison and his light bulb, Gustaf Dalén and his revolving lighthouse, Gustaf de Laval and his milk separator, Alexander Graham Bell and his telephone. Such inventions are certainly important, but they are only a small part of the flow of innovations, which often consist of small changes to existing products to make them more functional, more economical, more user-friendly, and less harmful to the environment.⁷ And innovations apply to services as well—and to forms of production, sourcing, marketing, transport, and logistics.

1.5.1 The Flow of Knowledge

Based on this broader view of innovation in a mature service economy such as Sweden, we argue that innovation policy must stand on two pillars⁸:

• First, knowledge building through schools, universities, and R&D institutions, in addition to upgrading and extension of the knowledge base—for example, through a sensible policy regarding cutting-edge research.

• Second, knowledge dissemination throughout the economic system and society at large. Knowledge must flow freely and be exploitable by entrepreneurs starting their own businesses or by intrapreneurs working in incumbents to develop and augment their operations. Hence, knowledge is commercialized in the form of innovations—that is, transformed into goods, services, and organizational changes that can survive and thrive in the marketplace.

The first of these tasks is central to innovation capacity. But to fully leverage knowledge investments, they must be complemented by policies that create favorable conditions for knowledge to be applied and commercialized. We perceive an imbalance between these policy areas.

For smaller countries such as Sweden, dissemination of knowledge, combined with cutting-edge knowledge in a few key areas, is a more effective instrument for the promotion of innovations than the accumulation of completely new knowledge. Dissemination of knowledge requires a high absorptive capacity to comprehend and convert research developed by others into innovations.⁹ The knowledge required to generate successful innovations does not solely relate to goods and services, but also involves understanding consumer preferences, markets, and financial opportunities. Such knowledge is fragmentary and dispersed. Various parts of it reside in the minds of diverse individuals in different organizations and in different places. Often, the average local business leader or politician (not to mention the most knowledgeable of economists!) has access to no more than a fraction of the knowledge required to make the right decisions. In addition, human error permeates all links of the chain. For this reason, the flow of knowledge is important.

Dissemination takes place most efficiently and most rapidly in “knowledge-intensive environments,” often in the form of the so-called clusters of companies and networks that are closely linked within one or a few related industries. Innovations seem to thrive in the type of environments where businesses can simultaneously act as competitors, customers, and subcontractors. Supporting and developing such skill clusters or blocks through various policy measures are therefore important ingredients in an innovation policy (Braunerhjelm and Feldman 2006). Cities in particular are important engines of innovation (Acs 2002; Moretti and Thulin 2013; Florida et al. 2017).

1.6 The Importance of the Entrepreneur

We disagree with the perspective that knowledge should be seen as the engine of the economy rather than the fuel. Other mechanisms are required to convert knowledge into something of societal value. One mechanism is entrepreneurship, a quality residing in specific individuals who can absorb disseminated knowledge and transform it into new or improved goods and services, better organization, higher efficiency, or other aspects that generate consumer value.

The entrepreneur has a dual role. As we have noted, he or she translates new knowledge into actual change. Entrepreneurs also deal with uncertainty, i.e., noncalculable risk. It is never known in advance how much new knowledge, or combinations of knowledge from different points in time, is worth or how its value can be realized. In the case of a product innovation, for example, it is virtually impossible to predict how it will be received by the market. In practice, some measure of genuine uncertainty is always present. As entrepreneurs engage in innovative activities, knowledge is further refined and diffused. Hence, it is the entrepreneur who experiments, investigates, and innovates, i.e., identifies new business opportunities and takes them to market to see if they can be successfully commercialized.

1.6.1 Diverse Types of Entrepreneurs

Entrepreneurs work in different ways and in different constellations. They may work on their own, either as an innovator or self-employed, but also in networks and organizations—a business, government agency, or educational institution. In such organizations, the search for new knowledge is often organized according to fixed routines. Specific persons are assigned to conduct R&D and to monitor knowledge development elsewhere, deciding what may be relevant to their own organization.

Sometimes this type of entrepreneurial person will leave a large organization to start their own business and pursue their dreams, thus creating a spin-off company. Sometimes an entrepreneur is forced by necessity to start anew, in a situation where permanent jobs are scarce. Another may strive to exploit a business opportunity they believe they have identified. Even if acting as an entrepreneur may simply be a way of making a living, this can sometimes develop into a genuinely entrepreneurial business. Entrepreneurs can thus appear in several shapes and sizes.¹⁰

The entrepreneur can be found in every industry. It is striking how Swedish innovators in recent decades have contributed not only to the development of new industrial products such as ulcer medication, cell phones, digitized devices or markets, or specialized steel products. They have also been successful in providing services in fields such as logistics, communication, and social welfare. Thus, Ingvar Kamprad, the founder (and until his death sole owner) of IKEA, should be numbered among the great Swedish innovators and entrepreneurs, revolutionizing the furnishing business through flat-pack delivery and constant improvement of the logistics chain during the course of six decades. Similarly, Sweden can boast of Niklas Zennström, who with Skype transformed our way of communicating via the Internet, and Spotify founders Daniel Ek and Martin Lorentzon, who have done the same for the music industry.

The fact that the entrepreneurial person can function in so many different roles and places also means that the innovation process can vary widely. Entrepreneurs who work in large firms (often known as intrapreneurs) can, via their R&D departments, personnel, HR departments, and so on, develop new products or processes that the firm itself can commercialize and where financing takes place internally, via bank loans, retained earnings, or the bond market.

Entrepreneurs in start-ups or small businesses often lack the necessary financial strength. In that case, the solution is either for the entrepreneurs to sell their knowledge (product, process, etc.) to other incumbent firms, or to receive financial support from the state, venture capital or private loans during the period preceding commercialization. Some results indicate that the second model—where the entrepreneur develops the innovation and then sells or licenses it to an incumbent—has been the most successful path to commercialization and diffusion of knowledge in Sweden (Braunerhjelm and Svensson 2023). However, this may indicate that conditions for expanding on promising activities are unfavorable. For example, there may be a shortage of competent venture capital, i.e., external investors who contribute management skills, networks, and industry expertise in addition to financial backing. Nevertheless, there seems to be a consensus that new, young, and small firms account for a disproportionately large share of radical and groundbreaking innovations (Baumol 2010; Haltiwanger 2022).

1.7 The Crucial Role of Government

Even though the government may provide the basis for a functioning market economy by establishing an institutional framework that guarantees that property rights are not violated, entry barriers are low, and competition is fair, this is not sufficient to foster innovation activities in an optimal way. Given that the basic pillars of innovation are knowledge creation and knowledge dissemination, other complementary measures are required. The classic example is the provision of education services. Education also generates positive external effects. This means that education provides greater socio-economic benefits than “merely” raising the individual’s level of education and income-earning capacity—it also raises the competence of society as a whole and, indirectly, its capacity for innovation and cultural and technological development. Moreover, it endows individuals with absorptive capacities to comprehend and process flows of knowledge. Therefore, it is economically effective for the government to support education. Thus, in almost all countries, compulsory schooling is more or less free, while various forms of scholarships and student loans assist the less fortunate to further their studies (at least in wealthier countries).

Correspondingly, R&D expenditure not only benefits the private investors in question, but it also gives rise to knowledge spillovers that benefit society at large. Consequently, there is a rationale for governments to fund and undertake R&D, particularly basic research that contributes to the accumulation of a larger knowledge stock for which any commercial applications are not yet known. A similar argument could be used for the training of researchers, i.e., PhD programs. This is also the rationale for government co-funding of private R&D investments through tax deductions or grants.

In the same way, infrastructure—both physical and virtual—has positive external effects. In addition to the purely economic benefits of trade and transport, people are exposed to travel, receive an education, enjoy new experiences, and learn about other parts of the world far away from their native countries. Infrastructure and communication networks are thus critical for the flow of knowledge and innovations, and the government fulfills an important role in these areas.

A financial market strongly focused on short-term returns is not the best tool for financing investments where uncertainties abound but potential societal benefits are significant. However, long-term returns, as the name implies, do not appear immediately—a circumstance apt to dissuade private investors. This is why governments frequently initiate support schemes for start-ups in the form of seed funding and access to certain services as well as for investment and the development of technology. Different forms of support exist depending on where in the development chain the company and its innovations are positioned. It is a delicate task to design such policies, since overly generous support risks wasting resources, leading to excessive risk-taking and reduced personal effort. The best option seems to be a balanced collaboration between private and public venture capital (Lerner 2020), where the entry conditions for both sides are clearly spelled out in a contract that also stipulates when and under what conditions one party can withdraw or take over the enterprise in its entirety.

In addition to these initiatives, which are primarily aimed at financing new products in young firms, there are many more factors that affect the inclination to innovate. A successful innovation policy must therefore infuse a broad policy spectrum. We will elaborate at length on this issue in the following chapters. The fact is that most governmental measures in the form of taxes and regulations affect people’s willingness to absorb new knowledge, take risks, and think afresh in one way or another—often more effectively than systems of subsidies can, as these easily become opaque and vulnerable to rent seeking.

1.8 Sweden in an International Perspective: Some Country-Level Comparisons

As already noted, Sweden has had positive development since the mid-1990s, especially in terms of macroeconomic stability. In general, Sweden has moved upwards in a number of international rankings of economic development as shown above in Table 1.1. These rankings are based on a mix of subjective valuations and actual statistics. We conclude this chapter by providing some key development indicators and compare Sweden with a selected number of other wealthy countries over a somewhat longer period according to our two pillars, knowledge building and knowledge dissemination. We start by looking at the development of GDP per capita and conclude by presenting the distribution of the Swedish labor force across industries.

Figure 1.3 shows that most countries have enjoyed encouraging GDP-per-capita growth rates since the late 1990s, although the trend stalled somewhat after the 2008–2009 financial market crisis. Sweden recovered fairly quickly from this financial turbulence and was among the top economic performers until 2020. As a result, the increase in Swedish GDP growth has been strong but not exceptional compared to similar countries.

Fig. 1.3

GDP per capita in selected wealthy countries, 1991–2021 (index 1991 = 100). Source: World Bank National Accounts data and OECD National Accounts data

1.8.1 Knowledge Accumulation

Turning to the most prominent measure of knowledge accumulation, Fig. 1.4 depicts how R&D expenditure has evolved in relation to GDP. Sweden has long been characterized by high expenditures for R&D, predominantly by its large, technology-based multinational companies. For the last 40 years, Sweden has held a top position when countries are ranked according to R&D spending relative to GDP (Fig. 1.5). Denmark, Finland, Germany, Switzerland, and the United States have also invested heavily in R&D, whereas the EU average is about one percentage point lower. The United Kingdom trails behind the other countries in this group.

Fig. 1.4

R&D expenditure as a share of GDP in selected wealthy countries, 1981–2021 (%). Source: OECD

Fig. 1.5

R&D expenditure as a share of GDP (%) and per capita (PPP$), 2019. Source: OECD, Main Science and Technology Indicators, Volume 2021/2, Table 2 and 4

R&D investment dominates in the business sector, where approximately 75% of R&D spending is private while the remainder is attributed to the government, other public sources, and the European Union. R&D spending is obviously an important precursor to innovation (we return to this issue in Chap. 2). However, there are some slightly ominous signs. From an R&D investment peak in Sweden of approximately 4% of GDP in 2001, the share is now down to 3.5%. A limited number of industries and businesses account for the bulk of private R&D expenditure: pharmaceuticals, ICT, automobiles, trucks, and instruments. Thus, if the leaders among these industries decide to outsource or relocate, Sweden’s aggregate R&D intensity will surely suffer. AstraZeneca’s decision several years ago to relocate part of its R&D from Sweden to other countries is a cause for concern. Ericsson’s restructuring and Nokia’s weakened position led to a sizable downward shift in R&D spending in Sweden and Finland in 2001 and 2010, respectively.

If the comparison is limited to 2019, although the group of countries is extended, it is obvious that Israel and South Korea play in a league of their own (Fig. 1.5). Sweden is ranked just after Taiwan in fourth place and ahead of all other EU countries. Applying the alternative measure of R&D per capita, some shifts in the rankings can be observed. In particular, the United States improves its position while China sinks to the bottom together with Turkey. Germany, Norway, and Luxembourg also climb the ladder, while Sweden drops to fifth place. Nevertheless, the Swedish position remains strong in an international comparison.

When we disaggregate R&D spending to different sectors and compare multiple outcomes, Sweden still retains a leading position (Fig. 1.6) compared with the OECD median and the median of the top five countries. Regarding the latter category, Sweden belongs to this group for five out of six indicators: total R&D spending as a percentage of GDP, business sector R&D spending as a percentage of GDP, higher education sector expenditure on R&D as a percentage of GDP, number of researchers per thousand inhabitants, and number of scientific publications per thousand inhabitants.

Fig. 1.6

The Swedish research system in international comparison, 2020. Note: Sweden’s position is shown in relation to the median value for all OECD countries and the median value for the top five OECD countries. The figure also contains a gray area, which shows minimum and maximum values for the top five countries. Source: GERD, BERD, HERD from OECD. Publications per thousand inhabitants and citation impact from Scimago

Another measure of accrued knowledge is the share of population enrolled in tertiary education. Figure 1.7 shows that Sweden is in an intermediate position compared to the other countries. The Swedish trajectory turned downwards in the early 2000s, unlike most other countries where the share of population enrolled in tertiary education continued upwards or remained stagnant. However, since 2013, the trend has again been moving upwards and by 2019, Sweden had caught up with Germany. It should be noted that the level of education not only captures knowledge accumulation but is also a prerequisite for absorption of new knowledge.

Fig. 1.7

Gross enrollment in tertiary education in a number of wealthy countries, 1971–2020 (%). Note: Gross enrollment rate is the ratio of total enrollment, regardless of age, to the population of the age group that officially corresponds to the level of education shown. Tertiary education, whether or not to an advanced research qualification, normally requires, as a minimum condition of admission, the successful completion of education at the secondary level. Source: UNESCO Institute for Statistics (UIS). UIS.Stat Bulk Data Download Service, https://apiportal.uis.unesco.org/bdds

1.8.2 Knowledge Diffusion

We now turn our attention to the second pillar required for innovation, knowledge diffusion. Total factor productivity (TFP)—that is, the increase in productivity that cannot be attributed to increased investment or employment—is often used as a (rough) measure of technological change, innovation, organizational change, and restructuring. Hence, it is an indicator of knowledge being applied for commercial purposes which in turn leads to structural change.

Sweden shares the experience of faltering TFP growth with most other countries, even though there has been a modest increase since 2009 (Fig. 1.8). But it is not comparable to the trend prior to the financial market crisis. The pattern here among countries is considerably more heterogenous than in the previous graphs, where some countries have experienced no or very modest increases in TFP since the early 1990s (Switzerland), while others have enjoyed a fairly robust growth since the financial crisis (United States). Finland’s very strong performance between 1991 and 2007 has not recurred since the financial crisis.

Fig. 1.8

Total factor productivity (TFP) in a number of wealthy countries, 1991–2021 (index 1991 = 100). Source: OECD

Entrepreneurship has been identified as another important diffusion mechanism (Acs et al. 2009). Initially dominated by large businesses and an expansionary government sector, Sweden has developed a more dynamic entrepreneurial environment in the last three decades (Fig. 1.9). The seeds for this trend were sown in the latter part of the 1990s, but when the IT bubble burst in early 2000, the result was a backlash for the entire entrepreneurial ecosystem. However, a new wave of entrepreneurs emerged around 2004, more experienced and better suited to handle the challenges that start-ups face. Since then, Sweden has been the breeding ground for many of Europe’s Unicorns (young companies valued at more than one billion USD). Still, entrepreneurial activity has also increased in other countries, and Sweden’s position is intermediate when compared to similar countries.

Fig. 1.9

Total early-stage entrepreneurial activity (TEA), 2001–2022 (%). Note: Defined as the percentage of 18–64-year-olds who are either nascent entrepreneurs (0–3 months) or owner-manager of new businesses (3–42 months). Source: Thulin (2023)

Finally, Fig. 1.10 presents the evolution of total manufacturing employment and by R&D intensity as a share of total employment. The more R&D-intensive manufacturing industries (high- and medium-tech production) have almost halved their employment share over the longer term, from 7.9% in 1980 to 4.2% in 2021. This decline coincides with a general pattern of a shrinking production share for manufacturing while the service sector grew from 56% in 1980 to 78% in 2019. Part of this increase is related to the strong growth in the employment share of knowledge-intensive business services (KIBS), which increased by 33% between 1990 and 2019. Distributed value chains and firm-level strategies that focus on core production and procure components and services, which has led to outsourcing, are some of the explanations for the altered production structure. It is obvious that services that used to be kept within manufacturing firms have migrated to other branches and firms. Previous studies on the knowledge base of the Swedish industry claim that the level has not decreased, rather the opposite, albeit there has been a change in the composition where the service sector, particularly business-related services, has increased its share considerably in the last decades (Hagman et al. 2015).¹¹ The increase in the share of employees in the knowledge-intensive sectors seems like an inevitable development given the rapid automation and outsourcing of non-core activities in manufacturing.

Fig. 1.10

Total manufacturing employment and by R&D intensity as a share of total employment, 1980–2019 (%). Note: Data on scientific R&D are only available between 1993 and 2018. Source: OECD STAN Database

Thus, there has been a pronounced shift towards service production in Swedish industry. On the other hand, the base for advanced manufacturing production is relatively thin in terms of employment. The employment share in manufacturing has been decreasing more or less continuously since the 1980s. However, this trend is counterbalanced by the increase in advanced service production. In general, Swedish industry specializes in the mid-tech segments, where future competition can be expected to be particularly fierce. However, it should be emphasized that the boundaries between industry and services is becoming increasingly blurred as activities are moved out of “pure” industrial manufacturing into industry-related services. A large proportion of the activities now carried out in the service sector previously took place within industrial enterprises.

This introduction has provided rather general outlines; in the following chapters, we will examine in more detail what theory and empirical data indicate on the topics of innovation and entrepreneurship. Then we will return to our policy recommendations.