Successful innovation relies on a supportive business environment. A poor business environment can substantially increase the cost of developing new products and make returns to innovation much more uncertain, undermining firms’ incentives to innovate. In some cases it may prompt start-ups and other innovative firms to move their activities elsewhere, resulting in an “innovation drain”.

Strikingly, firms that have recently introduced a new product tend to regard all aspects of the business environment as a greater constraint on their operations and growth than firms that do not innovate. These differences between the views of innovative and non-innovative firms are particularly large when it comes to corruption, the skills of the workforce and customs and trade regulations.

From a geographical perspective, they tend to be larger in Central Asia, the EEC region and Russia. In the CEB region, by contrast, these differences are less pronounced, suggesting that the overall environment there may be more supportive of innovation.

Firm-level and cross-country analysis has identified a number of factors that play an important role in shaping firms’ incentives and ability to innovate, as well as innovation outcomes at country level. In the case of the latter, the factors that determine a country’s patent output are not necessarily the same as those that determine the innovation intensity of a country’s exports. For example, countries that are rich in natural resources tend to have less innovation-intensive exports, despite patenting levels that are comparable to those of other countries.

Overall, the analysis in this chapter suggests that efforts to further improve the innovation potential of firms and economies in the transition region should primarily target reductions in corruption, greater openness to international trade and cross-border investment (including effective customs and trade regulations) and improvements in the skills of the workforce. Other factors, such as improved access to finance and the upgrading of ICT infrastructure, also play an important role.

This analysis also reveals the relative scarcity of innovative start-ups in the transition region. While larger firms that have been around for a longer period of time tend to innovate more – particularly in high-tech manufacturing sectors, where innovation is more dependent on R&D – smaller and younger firms are often the ones developing products that are new to the global market.

In Israel, young, small firms are more likely to introduce world-class innovations than larger, established firms, but in the transition region this is not the case. On the contrary, innovations introduced by young, small firms in the EBRD region are less likely to target the global technological frontier than those of larger firms.

The analysis in this chapter supports the view that R&D activities increase the likelihood of successful innovation, but are by no means a prerequisite for innovation. The impact that R&D activities have on the likelihood of a new product being introduced is particularly large in high-tech manufacturing sectors. Meanwhile, R&D in low-tech sectors can help to optimise production processes. Lastly, while both business R&D and government R&D increase a country’s patent output, only business R&D has a significant positive impact on the innovation intensity of a country’s exports.