Why Jobs in Innovation Will Keep Increasing

In 2007 a twenty-seven-year-old entrepreneur named Sam Lessin cofounded the Web startup drop.io, which was intended to make real-time file sharing and collaboration easy for people. Three years later, in a major coup, Lessin sold his startup to Facebook. Immediately after paying millions of dollars for the company, Facebook did something unexpected: it shut down drop.io. As it turns out, what Facebook had wanted all along was Sam Lessin. It is part of a new phenomenon that has emerged in Silicon Valley: large established companies buy entire startups not to acquire groundbreaking new technologies but to acquire the people who thought of them in the first place.

 This is typically great news for those working in the companies that are acquired, as it translates into generous salaries and stock options. The New York Times recently reported that in 2009, Facebook bought FriendFeed, a company that helps people track the online activities of their friends. “Tech insiders thought it was trying to compete more effectively with Twitter. But Facebook was really after FriendFeed’s dozen well-regarded product managers and engineers,” including its cofounder Bret Taylor. The price tag for FriendFeed is estimated to be $47 million, or $4 million per employee. “We really wanted to get Bret,” Mark Zuckerberg, Facebook’s chief executive, remarked at the time. “Someone who is exceptional in their role is not just a little better than someone who is pretty good,” he went on to say. “They are 100 times better.”

Zuckerberg’s comments are particularly revealing. The rise of the innovation sector is associated with an increase in the value of talent, for a simple reason: economic value depends on talent as never before. In the twentieth century, competition was about accumulating physical capital. Today it is about attracting the best human capital. What Zuckerberg was effectively saying is that the economic returns on new ideas have never been so high, and the rewards for those who can come up with good ideas have also increased. “Engineers are worth half a million to one million,” Vaughan Smith was reported as saying in the same New York Times article. He should know. As Facebook’s director of corporate development, Smith was behind Facebook’s acquisitions of more than twenty “talents” in the past four years.

Why have the economic returns on new ideas increased so much? After all, you would think that even thirty years ago having a new idea would have created a great deal of economic value. What has changed? Fundamentally, there are two reasons for this increase: globalization and technological progress. Remarkably, the same two forces that have caused the demise of blue-collar jobs are now fueling the rise of jobs in the innovation sector.

 Increased globalization is particularly good news for innovative companies. The reason is simple, although often ignored in the political debate on jobs and globalization. Innovative industries are fundamentally different from all other industries in how they make their profits. Take software: coming up with an idea for a new piece of software, developing it, and testing it is expensive, but when the software is written, it can be reproduced millions of times at virtually no cost. Most costs incurred by Microsoft in developing new versions of Windows—the backbone of its commercial success—involve paying engineers to write software codes. These costs are largely fixed, in that they do not depend on how many copies of Windows are sold. The variable costs—the cost of the physical CD-ROM on which Windows is actually written and the cost of the cardboard box in which it is shipped—are trivial. This means that it costs Microsoft billions of dollars to make the first copy but only a few cents to make the second. A global market enables the company to sell vastly more copies without increasing production costs. The same is true for Internet services, pharmaceuticals, digital media, and most products that involve significant up-front R&D costs. Google spends millions every month to improve its search engine. The cost of this investment does not vary whether ten people use the company’s website or one billion use it. The only thing that varies is its profits. Similarly, most of the cost of making a new drug entails up-front research investment. The cost of making the actual pill is minor.

In most innovative industries, the main production costs are the fixed costs of research and development. The variable costs of production are typically low. Having access to global markets dramatically raises the returns on creating new ideas by increasing sales without increasing costs. It is therefore not surprising that the resources devoted to innovative activities have reached unprecedented levels. This is important not just for the bottom line of innovative companies but for the creation of jobs. These features of innovative industries stand in contrast to traditional manufacturing, where fixed costs can be large but variable costs are also significant. For example, when making cars or clothes, each additional unit significantly adds to total costs. Thus the benefits of larger markets are less pronounced in traditional manufacturing than in innovation.

 The effect of globalization is strengthened by the expansion of the global middle class. As countries such as China, Brazil, and India become more prosperous, they demand more high-end products. This trend tends to favor innovative industries. American exports to China have increased almost 500 percent, more than ten times faster than exports to the rest of the world. A large percentage comes from California, Washington, and Texas in the form of advanced products such as software, scientific instruments, medical machines, and aerospace products.

Still, numbers aside, there is widespread unease about globalization. Surveys consistently indicate that the majority of Americans, including those in the innovation sector, believe that globalization is one of the main causes of America’s economic problems. Eric Scott is a good example. He is an experienced hardware engineer and has worked in high tech most of his life. A couple of years ago he landed a good position at Dolby Labs, a high-tech company in San Francisco that makes digital sound systems for cinemas and audio applications for DVDs. Scott has a wife, a three-year-old daughter, and a new mortgage on a house not too far from the Dolby R&D facility. He has noticed that over the years Dolby has been experimenting with outsourcing parts of the innovation process to cheaper locations in Asia. So far it does not appear that this outsourcing process has taken off in his company, but he can easily imagine a future in which most innovative work, including his own, is outsourced. Is this where we are heading?

 Until recently, most developing countries have focused on labor-intensive, low-skill manufacturing sectors that compete primarily on price. But at some point they may get tired of being mere producers of goods “designed in California.” China already produces more patents than Germany and France. To be sure, the quality of these patents, as measured by citations by other patents, is still low compared to those of Western countries.3 Nonetheless, it is undeniable that innovation in China and India is steadily increasing over time.

While outsourcing causes job losses in most parts of traditional manufacturing, the opposite is true for the innovation sector. How is this possible? Recent research shows that more assembly jobs in China and more customer assistance jobs in India ultimately mean more R&D jobs in America as well as more jobs for the professionals—advertisers, designers, analysts, accountants—who cluster around high-tech companies. Let’s consider Oracle, the giant maker of business hardware and software. In 2000, Oracle had 22,008 workers in the United States and 20,919 workers abroad. Today Oracle has 40,000 workers in the United States and 66,000 abroad. While the U.S. share has declined, the actual number of American jobs has increased. Crucially, the best-paid jobs, the ones in R&D, are still overwhelmingly in the United States, and their number has increased significantly. As James Fallows once put it, Indian and Chinese workers “making $1,000 a year have been helping American designers, marketers, engineers, and retailers making $1,000 a week (and up) earn even more. Plus, they have helped shareholders of U.S.-based companies.”

 To see how this works in practice, consider the case of life sciences research. Over the past decade, many American biotech and pharmaceutical companies moved part of their R&D activity abroad. Dr. Vinita Sharma is the head of the Indian government’s National GLP Compliance Monitoring Authority, Department of Science and Technology, which is India’s equivalent of the U.S. Food and Drug Administration. She is an intense, cosmopolitan woman with vast experience in research and policy. She has a vision: Indian-made R&D services on demand. When I met her, she was in an excellent mood. India was about to receive certification from the OECD to operate preclinical test labs for pharmaceuticals, industrial chemicals and agrochemicals. The certification meant that India could now offer a vast array of laboratory tests to European and U.S. life science companies. “You have an idea in the U.S., Germany, or China, we will provide you with good R&D,” she said. “We want to convert knowledge to wealth.”

This is exactly the sort of initiative that terrifies American workers. How will it affect their jobs? The effect could be positive or negative, depending on whether the hiring of more foreign R&D workers induces American companies to hire more or fewer workers in the United States. In economics jargon, it depends on whether foreign workers are complements or substitutes for workers here. A series of studies by the Dartmouth economist Matthew Slaughter suggest that outsourcing is not a zero-sum proposition, because overseas workers are generally a complement to rather than a substitute for U.S. workers: for every job outsourced by American multinationals, nearly two new jobs are created in the United States. This is a good deal for American workers. Those new jobs tend to be positions in research and development, marketing, engineering, design, and science. They command good salaries and offer significant potential for career advancement. One of the most comprehensive reports on offshoring in technical fields, produced by the National Academy of Engineering, agrees: “Offshoring appears to have contributed to the competitive advantage of U.S.-based firms in a variety of industries.”    

 Globalization is not the only reason that jobs and salaries in innovation are growing. When a company successfully brings an innovation to the market—anything from the iPad to a new drug—it can often charge a price that is significantly higher than production costs. Economists call this an economic rent. In this respect, an innovative product is like a Versace handbag. In high fashion, the rent comes from the glamour of the brand. In high tech, the rent comes in the form of a patent that gives the innovator monopoly power.

Who ultimately benefits from the economic value created by innovations? Consumers benefit in the form of new or cheaper products. Companies benefit in the form of higher profits. The rest accrues to the workers involved in developing the product. This means more jobs and in some cases higher salaries. The economists Natarajan Balasubramanian and Jagadeesh Sivadasan used a highly confidential data set compiled by the Census Bureau to follow the inner workings of 48,000 American companies over twenty years. They found that both employment and labor productivity grow significantly in the year after a firm successfully patents its first innovation and that these positive effects persist for years afterward. The London School of Economics professor John Van Reenen examined the relationship between salaries and innovation in six hundred innovative firms in the United Kingdom. Focusing on innovations that are both technologically important and commercially successful, he found that the average salary in a company increases substantially as a result of innovation, peaking about three years after the introduction of a new product.

 Thus the economic rent created by innovations ends up benefiting not just CEOs and shareholders but also workers. The salary gains are substantial: overall, Van Reenen estimates that workers capture about 20 to 30 percent of the additional economic value created by innovation in the form of higher salary. This is one of the reasons that innovation is so important as an engine of job creation. As we saw in the case of the iPhone, there is little value in making standard products that can be produced anywhere in the world. But when the traded sector in a country makes products that are innovative and unique, it creates more and better jobs.

The supply of skilled and creative workers capable of innovating is increasing worldwide, as a growing number of young people in emerging economies obtain college and postgraduate education. But the demand for skilled and creative workers is rising even faster. The latest recession temporarily slowed this increase in demand, but in the long run, globalization and technological progress mean more jobs and greater rewards for the creative workers who produce new ideas and new products. While this is good news for American society as a whole, the effects of this shift on American workers are geographically uneven. The creation of new jobs is not spread uniformly over the entire country. It favors some cities and regions while ignoring others. Geography is becoming increasingly important. In the next chapter we will look at who wins and who loses in the new innovation economy and how these trends are reshaping the social fabric of American communities.