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Technological innovation is a critical driver of a country’s economic development and a firm’s long-term competitive advantage. According to a report issued by OECD in 2015, depending on the country, the level of economic development and the phase of the economic cycle, technological innovation (including technological progress embodied in physical capital, investment in knowledge based capital, increased multi-factor productivity growth, and creative destruction) accounts for around 50% of total GDP growth.[1] Emerging economies, such as China, have also realized the importance of technological innovation and put promoting innovation as their most important long-term national policies.
Given its importance, intensive theoretical and empirical research has been conducted to explore a variety of factors (including firm-level characteristics and legal, institutional, and financial sector developments) that affect the motivation and financing of corporate innovation in the past a few decades. This is especially the case most recently, largely because of the availability of high quality patent and citation data that could help capture a country’s or a firm’s innovation output. The Journal of Financial and Quantitative Analysis has played a critical role in promoting this line of research and deepening our understanding on important unanswered questions on the motivation and financing of corporate innovation. To highlight some of the key contributions it makes, I choose 6 fascinating papers published or forthcoming in the Journal of Financial and Quantitative Analysis for this virtual issue.
Innovation by nature is a long-term, risky, and idiosyncratic process that has high uncertainties regarding the outcome. An easy alternative to innovation is to wait, copy and free-ride on other firms. Yung (2016) develops a model and proposes a reason for why firms in a competitive market are willing to invest in risky innovative projects. He shows that, because 1) innovation involves costly investment and 2) useful information could be revealed by observing others’ innovation activities, internal financing leads all firms to wait for others to innovate first. When external financing is used to finance firms’ projects, however, the situation is different. This is because the terms of financing now depend on the investor’s perception of the firm’s quality, and this perception can be partially reflected in the firm’s innovation activities. Hence, in equilibrium, firms with higher quality would optimally take the lead innovate to signal their ability while those with lower quality would wait longer before doing so. This paper offers an information-based explanation for firms’ innovation endeavors and some key features of market-wide innovation waves across time.
Different from a time-series point of view on innovation waves in the previous paper, Gao, Hsu, and Li (2017) explore the research question in the cross section by comparing innovation strategies of public and private firms. Using a sample over the period of 1997 and 2008, they show that public firms tend to do more exploitative innovation as their patents rely more on existing knowledge. In contrast, private firms tend to do more exploratory innovation evidenced by the finding that private firms’ patents are broader in scope. They argue that a plausible underlying mechanism that could help explain this observation is the shorter investment horizon associated with the public equity market, which is a typical managerial myopia problem documented by the existing literature.
To mitigate managerial myopic behavior and encourage innovation, managers need to be offered some “insurance” mechanisms that could help them hedge against innovation risk. A CEO’s network can play such a role, as documented in Faleye, Kovacs, and Venkateswaran (2014). They explore a sample of 2,366 CEOs and 1,532 firms between 1997 and 2006, and show that firms with better-connected CEOs engage more in innovative activities and generate a larger number and higher quality patents. A main channel of their findings is that a CEO’s personal network connections provide her labor market insurance against career concerns inherent in risky innovation activities, so that it increases the CEO’s incentives to take more risks and invest in innovation. Access to innovation-related information via personal networks appears another plausible channel.
Besides CEOs’ personal network connections, a firm’s corporate governance plays important roles in corporate innovation as well. Sapra, Subramanian, and Subramanian (2014) examine the relative strengths of internal and external governance mechanisms in influencing firm innovation. Specifically, they develop a theoretical model and show a U-shaped relation between innovation and external takeover pressure. The tension in their model reflects the tradeoff between private benefits of control and expected takeover premium. One the one hand, choosing a more innovative project increases the firm’s likelihood of being taken over and increases the manager’s expected loss of control benefits. On the other hand, choosing the more innovative project would imply a larger expected takeover premium. These tradeoffs give rise to a U-shaped pattern. The authors find evidence consistent with their prediction that innovation is enhanced either by an efficient takeover market or by very severe antitakeover laws, using a sample of firms between 1980 and 1995.
Governance affects technological innovation not only at the firm level as suggested by the previous study, but also at the country level. This is especially true when a country’s culture is corruptive. Using a large sample of over 25,000 firms in 57 countries between 2002 and 2005, Ayyagari, Demirguc-Kunt, and Maksimovic (2014) document that innovating firms pay more bribes than non-innovating firms, and this observation is more pronounced in countries with weaker governance and more bureaucratic regulation. The authors further find that bribing innovators do not seem to benefit from either better services or better chances of engaging in other opportunistic activities, such as tax evasion. Actually, bribing innovators are more likely to be the victims of corruption. The findings in Ayyagari, Demirguc-Kunt, and Maksimovic (2014) suggest that a corruptive culture or political system could hurt technological innovation by placing extra burdens on the innovators
Shifting our attention from the effects of firm and country characteristics, individual behavior appears to affect technological innovation, too. Individuals’ gambling preference is such an example that has been studied by Chen, Podolski, Rhee, and Veeraraghavan (2014). Using the ratio of Catholics-to-Protestants to capture local attitudes towards gambling, they find that firms headquartered in counties in which gambling propensity is higher tend to undertake riskier projects, spend more on innovation, and generate larger innovation output. They argue that investment in innovation makes a company’s stock price more lottery-like, which is a feature desired by individuals who love gambling. Hence, local managers and investors’ gambling preferences influence firms’ innovative endeavors and output.
These 6 papers published or forthcoming in the Journal of Financial and Quantitative Analysis have collectively played an important role in enhancing our understanding of the motivation and financing of corporate innovation. An equally important question that has remained largely unanswered is the real and stock market consequences of corporate innovation. For example, do innovative firms grab more market share from their product market rivals and exhibit better operating performance? Do they hire more productive and innovative workers? Do they attract managers with better skills? In turn, do innovative firms exhibit better stock returns and higher market valuation? In terms of the effect of innovation on the labor market, do innovative firms spawn entrepreneurs and especially spur local entrepreneurship? Finally, how does corporate innovation at the aggregate level affect a country’s entrepreneurship, financial development, and economic growth? Hopefully, more high quality papers answering these questions will be published in the Journal of Financial and Quantitative Analysis, deepening our understanding on these issues.
[1] “OECD innovation strategy 2015: An agenda for policy action.” OECD Publishing, Paris.