Part 2 - Incremental and Radical Innovation
From continuous improvements to innovations that change technology, expertise and markets
Innovation does not have to be revolutionary. Much of the innovation that occurs in businesses consists of continuous improvements to products, services and processes that already exist. Other innovations involve much greater leaps and may require new technology, new expertise, new ways of working or completely new ways of meeting the market. The distinction between incremental and radical innovation is therefore fundamental in innovation research. But the distinction is not absolute. What appears to be a small improvement for one business may represent a significant leap for another.
Innovation has different degrees of novelty
When we ask whether something is innovation, one question is crucial:
How different is the new from what existed previously?
Some innovations build on established products, technologies, services and work processes. They improve existing features, reduce costs, increase quality or make the solution easier to use.
Others require far greater changes.
They can build on completely new knowledge, introduce new technological principles or make existing expertise less relevant. In some cases, they can also contribute to the establishment of new markets and value chains.
Innovation research has therefore long attempted to describe the degree of novelty .
The concepts of incremental and radical innovation are among the most important tools for doing this.
But the terms must be used with caution.
Radical innovation does not automatically mean disruptive innovation.
Incremental innovation does not mean insignificant innovation. And a technologically radical innovation does not necessarily have to create a correspondingly radical market change.
We must therefore first understand what the terms actually describe.
What is incremental innovation?
Incremental innovation involves improvements that build on existing knowledge, technology, products, services or work processes.
The business does not necessarily start over.
It further develops something it already knows.
A product can become more energy efficient. A manufacturing process can use fewer raw materials. A digital service can become easier to use. An online store can improve search, product information, or the payment process. A hospital can change its workflow so that patients receive treatment faster.
Each individual change may be limited.
But that doesn't mean the impact over time is small.
A long series of incremental innovations can deliver significant improvements in quality, productivity, costs and customer experience.
This is an important correction to the notion that “real” innovation must necessarily involve spectacular breakthroughs.
Much of economic and organizational development occurs precisely through accumulated improvements .
Incremental doesn't just mean small adjustments
It is also necessary to distinguish incremental innovation from ordinary operations and routine changes.
As we saw in Part 1, the OECD's Oslo Manual requires that an innovation involves a new or improved product or process that differs significantly from the actor's previous products or processes.
A regular software update, a cosmetic change, or the replacement of a machine with an identical machine is therefore not automatically innovation.
Incremental innovation involves continued real improvement .
The difference lies in the fact that the improvement builds on an existing development trajectory rather than representing a fundamental break with it.
This makes incremental innovation particularly important for established businesses.
They already have customers, expertise, products, production systems, and distribution. Through continuous innovation, they can improve these resources and create more value without having to replace the entire system.
What is radical innovation?
Radical innovation is located further from the company's existing knowledge and practices.
It may involve new technological principles, new areas of expertise or fundamentally new ways of solving a problem.
In the research literature, radicality has been defined in different ways. Some studies place particular emphasis on how much technological change the innovation represents. Others examine how much existing knowledge and expertise is challenged. Still others include market novelty.
Therefore, there is no single universal threshold at which an innovation suddenly goes from incremental to radical.
It is more precise to understand this as a continuum of novelty and change .
The greater the distance between the existing solution and the new one in terms of technology, knowledge, expertise or application, the more radical the innovation can be.
Schumpeter and the great leaps
Joseph Schumpeter did not necessarily use today's incremental–radical terminology in the same way as later innovation research, but his understanding of economic development is important for the background.
Schumpeter was concerned with how new combinations could break with existing economic structures.
New products, production methods, markets, raw material sources, and organizational forms could change how economic activity was organized.
Here also lies the foundation for his later perspective on creative destruction .
Innovation can create new opportunities while existing technology, businesses and expertise lose value.
However, this does not mean that all innovations have to be radical.
Recent innovation research has shown just how important it is to understand the interaction between the many continuous improvements and the rarer, larger leaps.
Abernathy and Utterback – innovation changes character
In the 1970s, William Abernathy and James Utterback made an important contribution to the understanding of how innovation develops throughout the life cycle of an industry or technology.
Early in the development of a new area, there can be great uncertainty about what the product will look like, what features customers will demand, and which technology will dominate.
Extensive product experimentation can therefore occur.
As a more dominant product architecture is established, the nature of innovation activity may change. Attention shifts more towards production, efficiency, quality and continuous improvement.
This perspective shows that radical and incremental innovation are not necessarily competing strategies .
They may be different phases or dimensions in a longer innovation process.
A radical technological development can be followed by decades of incremental innovations that make the technology cheaper, better, safer and accessible to far more people.
Henderson and Clark – when the simple dichotomy is not enough
Rebecca Henderson and Kim Clark showed in their classic article Architectural Innovation: The Reconfiguration of Existing Product Technologies and the Failure of Established Firms from 1990 that the distinction between incremental and radical innovation may be too simple.
They distinguished between knowledge about the individual components of a product and knowledge about how the components are connected together .
This provided the basis for a more nuanced model.
An innovation can retain much of the existing component knowledge, but at the same time change the architecture – that is, the relationships between the components – in a way that creates major challenges for established businesses.
This Henderson and Clark called architectural innovation .
The perspective is important because it shows that an innovation can look relatively moderate if we only examine its components, while at the same time fundamentally changing how the business must organize its knowledge.
It reminds us that the radicality of innovation cannot be assessed solely by how different the end product looks.
We must also ask:
What knowledge must the business master to develop and produce it?
Three real examples
LED lighting
The transition from traditional incandescent and halogen lamps to LEDs illustrates how a fundamental technological change can create a new starting point for a long series of improvements.
LED technology represented different physical principles for light production than the incandescent lamp. Over time, the innovation has been further developed through continuous improvements in light output, lifespan, production costs, color rendering, control and integration with digital systems.
The example shows how a major technological shift can be followed by extensive incremental innovation.
The electric car
Modern battery-electric cars illustrate how difficult it can be to place complex innovations into a single category.
The car as a means of transport is not new. Many basic components and functions have been continued. At the same time, electric powertrains, battery technology, software, energy management and charging infrastructure involve significant technological and organizational changes.
Then there is continuous incremental innovation in battery capacity, energy efficiency, software, manufacturing and charging.
The example shows why radicalism often has to be assessed on several levels simultaneously .
The smartphone
The smartphone combined technologies that already existed – mobile telephony, computing, the internet, touchscreens, cameras and software – in ways that eventually fundamentally changed how people communicate, work, shop and use digital services.
But here too, the first major transformation has been followed by continuous innovation.
Better cameras, processors, displays, batteries, sensors and software have improved the smartphone over many product generations, without each new model representing a radical innovation.
Thus, the smartphone illustrates both combination, major technological change, and long-term incremental development .
Radical innovation is not the same as disruptive innovation
This distinction is absolutely crucial.
The terms are often used as if they mean the same thing.
They don't.
Radical innovation primarily describes the degree or character of novelty and change.
Disruptive innovation describes a specific development mechanism in a market , as Clayton Christensen and later co-authors have formulated the theory.
A technology can therefore be radical without being disruptive.
And disruptive development does not have to start with the most technologically advanced solution.
This is so important that disruptive innovation gets its own specialist article in the next part of the series.
Incremental and radical innovation in the same business
Businesses are thus faced with a fundamental dilemma.
They need to improve what they already do. At the same time, they need to be able to explore solutions that could potentially make parts of their current operations less relevant. The two activities do not necessarily require the same expertise, organization, or management logic.
Incremental innovation can often build on existing customers, processes and knowledge. More radical innovation often involves greater uncertainty. Customer needs may be less clear. The technology may be immature. The market may be unknown. Existing measurement methods and decision-making processes may be poorly adapted to the projects.
Here we approach James March's classic distinction between exploitation and exploration .
The business must both utilize and improve what it already knows, and explore what it does not yet know will work.
Later in the series we will return to how Michael Tushman and Charles O'Reilly have developed this further through research on organizational ambidexterity .
From innovation to value creation
The connection to the Value Creation series is particularly clear here.
Incremental innovation can create significant value through accumulation.
A product that becomes a little more energy efficient every year, a logistics process that gradually uses fewer resources, or a public service that becomes easier to use through continuous improvements, can over time create enormous economic and societal value.
Radical innovation can open up completely new possibilities.
But it often involves greater risk.
New skills must be developed. Infrastructure may need to be built. Capital must be invested before results are known. Existing jobs and businesses may be challenged while new ones emerge.
This makes innovation's relationship to value creation more complicated than the notion that "new is better."
The interesting question is:
What new values are created, what existing values are affected, who gets to share in the values – and what resources are required to realize them?
Incremental and radical innovation in e-commerce and digitalization
Digitalization and e-commerce demonstrate very well how different degrees of innovation can exist simultaneously.
An online store can make continuous improvements to search, navigation, product information, payment, personalization, and logistics.
Each improvement can be incremental.
But the sum can significantly change the customer experience over time.
Other technological developments could create greater disruption. Mobile internet use changed the conditions for digital services. Cloud computing changed how businesses could purchase and scale data capacity. Artificial intelligence could change how knowledge work, search, consulting, programming and customer interaction are performed.
But here too we must avoid technological determinism.
New technology is not automatically radical innovation.
The radicality depends on how much change the technology actually represents in knowledge, solutions, processes or application.
In short
Incremental innovation builds on existing knowledge, products, services or processes and creates significant improvements without necessarily fundamentally breaking with what exists.
Radical innovation involves greater distance from existing technology, knowledge or practice and may require new competencies and solutions.
Between these extremes there are many degrees and combinations.
Henderson and Clark's research also shows that we need to examine both the components and the architecture between them.
And most importantly:
Radical innovation and disruptive innovation are not the same.
That distinction takes us directly on to the next article:
From theory to practice - BI, Oxford and San Francisco
The distinction between continuous improvement and major innovation leaps becomes particularly interesting when theory meets practice.
Through Innovation and Commercialization at BI , innovation can be studied as a process where ideas must be assessed, developed and brought forward towards application and market.
The Oxford Seminars represents the connection to academic reflection on technology, organizations, leadership and social development.
The San Francisco Seminars At the same time, it provides a natural practical perspective on environments where new technologies, entrepreneurship, capital, established businesses and new business models coexist closely.
The three perspectives are reminiscent of the same thing:
Innovation doesn't just happen in theory. It must be developed, organized, financed, tested and put into use.
Recommended literature
Innovation is a comprehensive field of research that has developed through contributions from economics, strategy, organizational theory, entrepreneurship, technology, and research on people and organizations. For those who wish to delve deeper into the theories and concepts covered in this series, there are a number of key original works and textbooks.
Among the most important contributions are Joseph A. Schumpeter's work on innovation, entrepreneurship and creative destruction, Peter F. Drucker's research and writings on systematic innovation, Clayton M. Christensen's theory of disruptive innovation and Henry Chesbrough's work on Open Innovation. Eric von Hippel's research on user innovation and lead users provides important perspectives on the role of users, while James G. March, Michael Tushman and Charles O'Reilly have had a major impact on the understanding of exploration, exploitation and organizational ambidexterity.
Teresa Amabile's research on creativity and organizations and Amy Edmondson's research on learning and psychological safety contribute to the understanding of the human and organizational prerequisites for innovation. The OECD and Eurostat's Oslo Manual is also a key international reference for how innovation is defined, classified and measured.
Through the individual articles in the Innovation series, relevant literature and research are presented in more detail. The goal is to return to key original sources where possible, while also using more recent research to show how the theories have developed, been challenged, and are applied today.
Authors: Clayton M. Christensen and Michael E. Raynor
Short review
In this sequel to The Innovator's Dilemma, Clayton Christensen shows how businesses can translate innovation theory into practical strategy. The book explains how companies can identify new growth opportunities, develop disruptive innovations, and build organizations that thrive in rapidly changing markets.
Why we recommend the book
While The Innovator's Dilemma explains why established businesses are often challenged, The Innovator's Solution provides concrete advice on how to meet the challenges. The book is therefore a natural next step for anyone who wants to understand innovation, strategy and long-term value creation.
Authors: Jeff Dyer, Hal Gregersen and Clayton M. Christensen
Short review
What characterizes people who create groundbreaking innovations? The authors identify five key skills – observation, questioning, experimentation, networking and association – that are common to the world's most innovative leaders and entrepreneurs.
Why we recommend the book
This book shifts the focus from organizations to the people behind innovation. It shows that creativity and innovation can be developed through deliberate training and experience. The perspectives align well with the philosophy behind Invisible Capital, where human competence and curiosity are the most important drivers of development.
Authors: Clayton M. Christensen, Taddy Hall, Karen Dillon and David S. Duncan
Short review
In this book, Clayton Christensen further develops the theory of Jobs to Be Done – the idea that customers do not primarily buy products, but "hire" them to solve specific needs. Through practical examples, the authors show how businesses can develop products and services that address customers' real-world challenges.
Why we recommend the book
For anyone working in customer experience, service design, and innovation, this is one of the most insightful books ever written. It reminds us that value creation always starts with understanding the people we are developing solutions for – a fundamental principle of Invisible Capital.
Author: Clayton M. Christensen
Short review
The Innovator's Dilemma is considered one of the most influential books on innovation and technological change. Clayton M. Christensen introduces the theory of disruptive innovation and explains why even the most successful businesses can fail when new technologies and business models challenge established markets. Through a series of examples, he shows how companies often focus on today's customers and incremental improvements, while overlooking innovations that later change entire industries.
Why we recommend the book
This is one of the books that has had the greatest impact on modern innovation thinking. When I first read it, it gave me a whole new perspective on why some businesses succeed in transformation, while others lag behind – even when they are well led. The insight has been an important part of my own understanding of digitalization, innovation and change management, and many of the reflections in The Invisible Capital build on the ideas Clayton Christensen presents in this classic. The book is as relevant today, in the face of artificial intelligence and digital transformation, as it was when it was published.
Author: Henry Chesbrough
Short review
Henry Chesbrough introduced the concept of Open Innovation and changed the way many businesses think about research and development. He shows how companies can create more innovation through collaboration with customers, universities, start-ups, suppliers and other external partners.
Why we recommend the book
Open Innovation has had a major influence on modern innovation thinking and was also an important topic during the seminars in Oxford and San Francisco. The book shows why future value creation occurs in the interaction between people, businesses and knowledge environments – not within closed organizations alone.
Authors: W. Chan Kim and Renée Mauborgne
Short review
Blue Ocean Strategy challenges businesses to shift their focus away from fierce competition and instead create new markets with little or no competition. The authors present strategies and models that help organizations develop innovative products, services, and business models.
Why we recommend the book
This book has inspired leaders around the world to rethink strategy and innovation. Instead of competing for the same customers, it shows how businesses can create new value through creativity and differentiation. The perspectives align very well with the themes of innovation, digitalization, and long-term value creation in Invisible Capital.
Authors: Patricia B. Seybold
Short review
Patricia Seybold shows how businesses can create better products and services by actively involving customers in the innovation process. The book describes how dialogue, co-creation and close collaboration with users can provide better solutions and stronger competitiveness.
Why we recommend the book
Customers often hold the most important insights into how products and services can be improved. This book emphasizes the importance of listening, involving, and learning from users – a perspective that is echoed in many of the articles on The Invisible Capital. Innovation rarely happens alone; it is created in the interaction between people.
Authors: Philip Evans and Thomas S. Wurster
Short review
This book analyzes how digital information is changing competitive conditions, markets, and business strategies. The authors explain how the internet is disrupting established structures and creating new opportunities for businesses that are able to think differently.
Why we recommend the book
Although written early in the internet revolution, the book describes many of the developments that still characterize business today. It provides valuable perspective on how digitalization affects value chains, competition, and innovation – themes that are central to Invisible Capital.
Authors: Don Tapscott and Anthony D. Williams
Short review
Wikinomics shows how openness, sharing and collaboration across organizations create new forms of innovation and value creation. Through a number of international examples, the authors describe how digital networks make it possible to develop products, services and knowledge together.
Why we recommend the book
This book was groundbreaking when it was first published, and many of the ideas have since become a natural part of everyday digital life. The perspectives on collaboration, knowledge sharing, and open innovation processes align very well with the philosophy behind Invisible Capital, where people and networks are at the center of value creation.
Author(s): Author: Michael E. Porter
Short review
Competitive Strategy is Michael E. Porter's classic work on how companies can understand the competition they find themselves in and develop a position that provides a basis for long-term profitability. Porter shifts the focus from the individual competitor to the structure of the entire industry and shows how competition is affected by customers, suppliers, new entrants, substitutes and the rivalry between existing companies. This forms the basis for what has later become known as Porter's Five Forces. The book is also about how companies can choose a competitive strategy on the basis of this analysis. It thus established an analytical language for strategy that has gained great importance in both research, teaching and practical strategy work.
Why we recommend the book
We recommend Competitive Strategy because it provides the analytical foundation for much of the thinking Porter later develops in What Is Strategy?. If a company is to choose a unique strategic position, it must also understand the competitive forces, the industry structure and the factors that affect the ability to create and retain value. The book is particularly useful because it reminds us that strategy is not just about internal goals, plans and ambitions. Strategy must be developed in the face of customers, competitors, suppliers, technology and structural changes in the market. Together with What Is Strategy?, the book therefore provides a much richer picture: First, the company must understand the competitive arena. Then, it must choose how to be different.
Author(s): Author: Michael E. Porter
Short review
In Competitive Advantage, Porter moves the analysis from the industry to the business itself. The main question is how competitive advantage is actually created. One of the book's most important contributions is the value chain, where the business is understood as a system of activities that collectively develop, produce, market, deliver and support a product or service. Competitive advantage cannot therefore be understood only through products or overall strategies; one must examine the activities that create costs, differentiation and value. This understanding later becomes central to Porter's argument about strategic fit: the activities must not only be good in isolation, but also fit together and reinforce each other.
Why we recommend the book
We recommend Competitive Advantage because it brings strategy right down to where value is actually created: in the activities the business performs. This makes the book particularly relevant together with What Is Strategy?. When Porter argues in 1996 that strategy consists of performing different activities than competitors, or performing similar activities in other ways, this builds on the thinking he developed here. For our perspective on value creation, this is particularly interesting. Value does not arise because the business has formulated a strategy on a document, but through people, expertise, technology, processes, collaboration and activities that together enable the business to create something that customers value. The book therefore provides an important connection between strategy, competitive advantage and actual value creation.
Author(s): Author: Michael E. Porter
Short review
In The Competitive Advantage of Nations, Porter raises the perspective from business to countries, regions and business environments. The book is based on extensive studies of the competitiveness of ten leading trading nations and examines why certain countries and business clusters are particularly successful in certain industries. A central premise is that national prosperity is not simply something a country inherits through natural resources or other given conditions. It is created, and productivity, innovation, competence, competition and the quality of the environment in which businesses operate are crucial. Here, Porter also develops the well-known diamond model to explain how different national and regional conditions can interact and stimulate competitiveness.
Why we recommend the book
We recommend The Competitive Advantage of Nations because here Porter extends the strategy perspective to the ecosystem surrounding the business itself. Value creation does not occur in a vacuum. Businesses develop in societies with education, research, infrastructure, capital, suppliers, demanding customers, competing businesses and public institutions. This makes the book particularly interesting for understanding value creation as an interaction between people, businesses and society. It also provides an important corrective to the notion that a country's competitiveness can mainly be understood through low costs or access to natural resources. Innovation, productivity and the ability to continuously develop are far more central to Porter's explanation.
Author: Joan Magretta
Short review
Understanding Michael Porter brings together and explains the most important parts of Michael Porter's strategic thinking in one accessible whole. Joan Magretta herself worked on strategy at the Harvard Business Review and organizes Porter's ideas around two fundamental questions: What is competition, and what is strategy? She explains, among other things, the Five Forces, competitive advantage, the value chain, value creation, trade-offs, fit, and strategic continuity. This makes the connection between Porter's various works clearer than when the concepts are studied separately. The book also includes an interview with Porter.
Why we recommend the book
We recommend Understanding Michael Porter because it helps the reader see the whole picture of Porter's understanding of strategy. Porter is often reduced to the Five Forces or a few models used in isolation. Magretta shows why this is too simple. Competition, value creation, strategic positioning, trade-offs, activity systems, fit and continuity are interconnected. This makes the book a particularly good supplement after reading What Is Strategy?. It makes it easier to understand why Porter does not view strategy as a plan or a collection of goals, but as a coherent system of choices about how the business will create value and compete over time.
Authors: Harvard Business Review, Michael E. Porter, W. Chan Kim, Renée A. Mauborgne and more
Short review
HBR's 10 Must Reads on Strategy brings together some of Harvard Business Review's most influential writings on strategy. The original collection from 2011 features Michael E. Porter's What Is Strategy? as its main article and combines it with works on competitive forces, Blue Ocean Strategy, the organization's vision, business models, strategy execution, and the Balanced Scorecard, among others. The result is not one unified theory of strategy, but multiple perspectives on how organizations can develop, formulate, and execute strategy.
Why we recommend the book
We recommend HBR's 10 Must Reads on Strategy because it places Porter in a broader strategic context. After reading What Is Strategy?, it will be interesting to encounter other central perspectives and see how they complement, challenge, or extend Porter's understanding. The collection also shows why strategy cannot be reduced to a single model. Competitive position, choice, innovation, business model, execution, priorities, and measurement must be seen in context. For the reader who wants to move on from Porter and into the strategy discipline more generally, this is therefore a very good introduction.
Author: Joseph E. Stiglitz and Bruce C. Greenwald
Short review:
Creating a Learning Society examines how knowledge, learning, and technological development contribute to economic growth and long-term value creation. Joseph E. Stiglitz and Bruce C. Greenwald challenge the notion that economic development is primarily about accumulating more physical capital. They argue that society’s ability to create, disseminate, and apply knowledge is crucial to productivity growth and improved living standards. A key point is that learning does not only occur in schools and universities. It also occurs in businesses, through work, production, innovation, and the interaction between people and organizations. Knowledge can also spread from one business and one part of the economy to others.
The book thus provides an important perspective on why human capital, competence, innovation and learning must be understood as central parts of a society's ability to create value over time.
Why we recommend the book
We recommend Creating a Learning Society because it expands the understanding of what lies behind economic value creation.
Machines, technology and financial capital are important, but they do not create productivity growth alone. Behind the development are people who learn, develop knowledge, improve work processes, share experiences and find new solutions.
This makes the book particularly relevant to Invisible Capital and our perspective on value creation: A significant part of society's value-creating capacity is found in the knowledge, competence, and learning ability of the people who participate in the economy.
Stiglitz and Greenwald thus provide an academic foundation for one of the most important relationships in modern value creation:
Author: Mariana Mazzucato
Short review
In The Value of Everything Mariana Mazzucato asks a fundamental question: What exactly is value – and who creates it? Mazzucato returns to the historical discussions of value in economics and shows how the understanding of value creation has changed. She challenges the notion that high income, high prices or high profits necessarily mean that correspondingly high values have been created. One of the book's most important contributions is the distinction between value creation and value extraction . Mazzucato examines the financial sector, the pharmaceutical industry, innovation and the public sector, among others, and argues that we must become better at distinguishing between activities that actually create new values, and activities that primarily extract values that have already been created.
The book also challenges the traditional notion that the private sector creates value while the public sector mainly consumes or redistributes it. Innovation and economic development often arise through a complex interaction between public investment, research, businesses, capital and people.
Author: Philippe Aghion, Céline Antonin and Simon Bunel
Short review
The Power of Creative Destruction is about one of the most important drivers of long-term economic growth: innovation.
Philippe Aghion, Céline Antonin and Simon Bunel build on Joseph Schumpeter's classic idea of "creative destruction" – the process by which new technologies, businesses, products and ideas challenge and replace existing solutions.
But the book is not just about the disappearance of the old. The authors examine why some economies manage to create continuous innovation and productivity growth, while others stagnate. Competition, entrepreneurship, research, education, institutions and public policy thus become important parts of the explanation.
Creative destruction also comes at a cost. New technologies and businesses create opportunities and jobs, but can also make existing skills, tasks and business models less relevant. The challenge is therefore to create societies that both promote innovation and enable people to participate in the transition.
Why we recommend the book
We recommend The Power of Creative Destruction because it shows why innovation is a fundamental driver of value creation .
Value creation is not just about producing more of what we already produce. It also occurs when people develop new ideas, technology, and ways of working that enable us to solve tasks better than before.
This makes the book particularly relevant to The Invisible Capital. Behind innovation are people with knowledge, expertise, creativity and experience. But Aghion's perspective also shows that human capital must be part of a larger system where competition, institutions, research, investment and policy create the conditions for new ideas to actually turn into economic and social development.
The book thus provides an important context in our understanding of value creation:
Knowledge → new ideas → innovation → productivity growth → long-term value creation.
Author: Philippe Aghion, Céline Antonin and Simon Bunel
Short review
Institutions, Institutional Change and Economic Performance is one of Douglass C. North's most important works on why some societies are more successful than others in creating economic development over time.
North shifts attention from traditional factors of production such as capital and labor to the institutions that shape how people, businesses, and governments act and cooperate. Institutions are society's formal and informal rules of the game – including laws, regulations, norms, traditions, and established ways of organizing interaction.
These rules of the game affect the incentives that people and organizations face. They also affect investments, knowledge development, cooperation, transaction costs, and which economic activities emerge.
North also shows that institutions develop over time. History therefore matters: Today's economic opportunities are influenced by institutional choices and development paths that can stretch far back in time.
Why we recommend the book
We recommend Institutions, Institutional Change and Economic Performance because it explains a crucial aspect of value creation that easily becomes invisible:
Value creation needs good rules of the game.
People may have knowledge. Businesses may have capital. Entrepreneurs may have great ideas. A society may have natural resources and advanced technology. But outcomes are also influenced by the institutions that determine how people can collaborate, invest, compete, make deals, and develop businesses.
This makes North particularly interesting for our understanding of trust as part of invisible capital. Trust is not the same as institutions, but stable rules of the game, credible agreements, and well-functioning institutions can reduce uncertainty and make economic interaction easier.
North thus gives us another important part of the value creation picture:
Institutions → predictability and incentives → cooperation and investment → productive activity → long-term value creation.
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