The Innovation Trap of Small Businesses

Abstract

This paper analyzes the "Innovation Trap" of Small and Medium Enterprises (SMEs), which constitute a central pillar of the Israeli economy, yet are characterized by low productivity and low rates of innovation adoption. The theoretical model developed in this paper offers a micro-economic explanation for this phenomenon, based on the interaction between two complementary constraints: the financial constraint, relating to the difficulty in raising capital for the required fixed investment, and the managerial time and attention constraint, reflecting the opportunity cost of the entrepreneur ׳s time. The model predicts an inverted-U relationship between profitability and innovation: businesses at the lower end of the profitability distribution are hindered by a lack of funding sources, while businesses at the upper end refrain from investing due to the high shadow price of managerial time. Consequently, a systemic market failure emerges, leading to under-investment in innovation. This failure is exacerbated in the periphery due to infrastructure gaps, which increase both direct financing costs and the learning and time costs required for technology adoption. To address this market failure, the paper proposes an applied policy tool: the Innovation Agents program. The program, to be operated in collaboration with the Small and Medium Business Agency, is based on training Economics and Management students within a new academic track for Innovation Economists and Consultants. Implementing this program is expected to increase productivity and reduce economic and regional disparities within the economy.