Discussion Paper No Firm Leadership and Innovative Performance: Evidence from Seven EU Countries. Dirk Czarnitzki and Kornelius Kraft

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1 Dscusson Paper No Frm Leadershp and Innovatve Performance: Evdence from Seven EU Countres Drk Czarntzk and Kornelus Kraft ZEW Zentrum für Europäsche Wrtschaftsforschung GmbH Centre for European Economc Research

2 Dscusson Paper No Frm Leadershp and Innovatve Performance: Evdence from Seven EU Countres Drk Czarntzk and Kornelus Kraft Download ths ZEW Dscusson Paper from our ftp server: ftp://ftp.zew.de/pub/zew-docs/dp/dp0135.pdf De Dscusson Papers denen ener möglchst schnellen Verbretung von neueren Forschungsarbeten des ZEW. De Beträge legen n allenger Verantwortung der Autoren und stellen ncht notwendgerwese de Menung des ZEW dar. Dscusson Papers are ntended to make results of ZEW research promptly avalable to other economsts n order to encourage dscusson and suggestons for revsons. The authors are solely responsble for the contents whch do not necessarly represent the opnon of the ZEW.

3 Frm Leadershp and Innovatve Performance: Evdence from Seven EU Countres 1 by Drk Czarntzk * and Kornelus Kraft ** forthcomng n Small Busness Economcs Ths Verson: March 2002 Frst Verson: June 2001 Abstract Ths paper consders the effect of dfferent frm leadershp on the nnovatve performance of frms from seven EU countres. We nvestgate whether owner-led or manager-led frms acheve a larger share of ther turnover wth product nnovatons. Economc theory does not propose clear answers to ths queston. In the emprcal analyss, t turns out that the manager-led frms are more actve nnovators: the share of sales based on new products s larger f frms managers do not hold any of the frms captal. Surprsngly, there are no dfferences between the seven countres ncluded n the regresson analyss. JEL-Classfcaton: O32, O31, D21, C24 Keywords: R&D, Product Innovatons, Manager, Tobt, Fractonal Response Model * ** czarntzk@zew.de, Centre for European Economc Research, Mannhem kraft@wpol.un-essen.de, Unversty of Essen 1 Ths study has been funded wthn the research project Innovaton-Related Knowledge Flows n European Industry: Extent, Mechansms, Implcatons of the Targeted Soco-Economc Research (TSER) framework of the European Commsson. The support s gratefully acknowledged. Moreover, we thank two anonymous referees for helpful comments on a prevous verson of ths study.

4 1 Introducton It s well known that the tradtonal textbook model of the owner-led frm s nadequate for large modern corporatons. Nowadays, these are led by managers, who are pad a fxed salary and addtonally receve a share of the frms realzed profts or turnover. However, the fxed porton of the remuneraton s usually much larger than the proft-related porton (Jensen and Murphy 1990) 2. The managers ncentves may be dfferent from those of tradtonal frm owners and therefore t s questonable whether manageral frms behave lke owner-led frms. The economc lterature ntensvely dscusses the consequences of manageral leadershp of the modern corporaton. One topc s the effect of leadershp on growth and the nvestment behavour related wth ths. It s frequently stated that managers - nstead of followng proftmaxmzng behavor - tend to nvest too much nto captal. The obvous reason for ths s to ntensfy growth of the frm, thus possbly rasng personal ncome as well as personal prestge and power. The purpose of ths paper s to pont to another possble dfference between manageral and owner-led frms: The pursut of nnovatve actvty. We dscuss the arguments aganst or n favor of nnovatve actvtes of manageral frms and subsequently we present the results of an emprcal study concernng ths topc. We use data from frms n fve sectors concernng seven European countres. All frms are small or medum szed wth a maxmum of 1000 employees. Overall, 474 observatons can be used. 2 Theoretcal Consderatons The dscusson on managers leads drectly to the well-known prncpal-agent models (see e.g. Mlgrom and Roberts, 1992). The man queston n these models s how to make the managers act n the nterest of the frms captal owners. Naturally, owners want to maxmze ther profts. Managers seek to optmze ther monetary and non-monetary ncome whch s related to profts but also to frm sze or smlar characterstcs. Emprcal studes show that manageral ncome s only weakly related to a frm s proftablty but rather strongly to frm sze (see e.g. Leech and Leahy, 1991, or Kraft and Nederprüm, 1999). There s no clear explanaton for ths phenomena. Rosen (1992) argues that the leader of a larger organzaton has a greater responsblty and f he or she s successful, the margnal product wll be hgher than at the top of a smaller company. Thus the mere observaton of hgher salares pad by larger frms says 2 Several studes besdes Jensen and Murphy (1990) have examned the dependence of management compensaton on performance [cf. Gbbons and Murphy (1990), Man (1991), Kaplan (1994a,b)] as well as punshment n the case of management falure [Wesbach (1988); Warner, Watts and Wruck (1988); Glson (1989); Fzel and Loue (1990)]. 1

5 nothng about the ncentve structure. Zábojník (1998) explans sales maxmzaton as a possblty to solve the problem of undernvestment nto specfc human captal. Rsk averson of the managers s clearly an explanaton (see among others Holmström and Mlgrom 1987) and ths leads to second-best solutons. The owners must take nto account the rsk averson of the managers, when they determne the salary. A very large varable component of the compensaton must be accompaned by a very large compensaton of the assocated rsk, whch means the expected (mean) ncome must be very hgh n order to produce the certanty equvalent, whch matches the utlty level of a lower but fxed remuneraton. As a consequence the varable part and the rsk compensaton have to be balanced, whch however makes frst-best solutons mpossble. If nnovatve actvty by the manageral frm s consdered, there are opposng forces at work. Every nvestment nto R&D actvtes s necessarly a rsky undertakng. The outcome of such an nvestment s unknown. Ths may perhaps have consequences for a manager, who s responsble for such decsons where falure mght lead to job loss. Presumably ths wll only occur f the projects have a great mportance for the frm, but t s a possblty. Ths argument would mply lower nnovatve actvtes than a tradtonal captalst frm would perform. As stated above, rsk averson s an mportant explanaton of the weak correlaton between proftablty and managers salares. R&D processes are by ther very nature rsky and therefore one can argue that managers are reluctant to nvest n such projects and prefer to follow establshed nvestment and merger actvtes. In contrast to the rsk argument, an opposng sze effect mght be present. It s a stylzed fact that managers ncome and also prestge as well as personal power are drectly related to frm sze. Therefore t s frequently hypotheszed that manager-led frms tend to grow faster than owner-led ones. The growth of frms s realzed among other determnants by mergers and captal nvestment. Many studes fnd that mergers are not proftable and therefore personal ams of managers must be responsble (among other reasons) for the observed merger actvtes. Other studes fnd that manager-led frms nvest too much nto captal and that the returns from nvestment are consderably smaller than the sum nvested (Mueller, 1999). Ths s evdence n favor of the so-called free cash-flow hypothess (Jensen and Mecklng, 1976). Our pont n ths connecton s the effect of leadershp on nnovatve actvty. The ntroducton of new products and new processes s obvously a consequence of earler R&D projects. Managers may pursue more R&D than the owner-led frm as t wll have an mpact on the development of new products and ths n turn wll lead to a larger sales volume. The theoretcal dscusson leads to contradctory effects. The manageral frm may show more, equal or less nnovatve actvty than the owner-led frm. The result depends on the relatve mportance of the rsk or sze argument. Our topc s the emprcal test of the behavour of managers and owners. We try to nvestgate whether manager-led frms show more or less nnovatve output than owner-led frms. Gven the evdence wth respect to nvestment 2

6 and mergers t seems to be an nterestng topc for emprcal research to compare the manageral frm wth the owner-led frm. Accordng to our knowledge untl now no emprcal study has consdered the effect of frm leadershp and ownershp on nnovaton performance of frms. Gven the mportance of techncal progress for ndvdual frms as well as for the whole economy, ths queston of leadershp does not seem to be a trval one. 3 Emprcal Fndngs Ths study uses survey data collected durng a research project funded by the European Commsson. The survey was carred out by means of Computer Aded Telephone Intervews (CATI). It s a cross-sectonal survey whch refers to the year The database contans nformaton on the frm level for fve sectors: Food and Beverages (NACE 3 : 15), Chemcals excludng pharmaceutcals (NACE 24 excludng 24.4), Manufacturng of Communcaton Equpment (NACE 32), Telecom Servces (NACE 64.2) and Computer Servces (NACE 72). The Countres ncluded are Denmark, France, Germany, Greece, Italy, the Netherlands and the Unted Kngdom. Furthermore, the survey was restrcted to frms wth 10 to 1000 employees. Ths enables a comparson between countres, whch typcally have very dfferent frm sze dstrbutons, lke e.g. Germany wth many large frms and Greece wth manly smaller ones. The typcal respondent n the ntervews s ether the head of the R&D department or f the frm dd not have ther own R&D lab, we contacted the person n charge of R&D actvtes or nnovaton, respectvely. Especally n the smaller frms, the ntervewee often was the general manager. Our data contans only very lmted nformaton on R&D expendtures. We measure the success of nnovatons as the share of sales resultng from sgnfcantly mproved or new products developed durng the recent three years (NewProd). Ths measure of nnovatve actvty s clearly an output of nnovaton projects and not an nput as, for example, R&D. We do not clam that our measure s superor to R&D or patents, but we thnk t s an nterestng alternatve to consder not only the pursut of R&D projects but also the mportance of the product nnovatons determned by the market. Unsuccessful R&D actvtes whch do not lead to new products or newly developed products whch have no success on the market are not measured as nnovatons because n a market economy t s ultmately the customers who determne the success of nnovatve actvtes. Our theoretcal dscusson consders R&D as the strategc varable, whch depends on the leadershp n frms. However, for obvous reasons there s a strong relaton between R&D and the ntroducton of new products. Several other studes were crtczed because they only use nput ndcators lke R&D expendture to measure nnovaton actvtes. Hansen (1992) argues: "Some frms may not be able to report resources devoted to nnovaton separately from resources devoted to other functons wthn the frm. If a 3 Nomenclature of Economc Actvtes n the European Unon (NACE). 3

7 porton of the company presdents tme s devoted to nnovaton, for example, t s unlkely that ths porton of hs or her salary wll be counted n the R&D spendng category". Especally, for small and medum szed enterprses ths problem s lkely to be true. Due to that fact, small frms would systematcally underreport ther R&D expendture. Regardng these crtcsms, we thnk that the share of turnover wth new or mproved products s s a useful alternatve measure of nnovatve actvty, especally for our sample of small and medum szed frms. The explanatory varables nclude ndustry dummes whch control for dfferent technologcal opportuntes n the fve sectors and country dummes that shft nter-country dfferences lke culture, organzatonal structures or market condtons. Furthermore, we control for sze effects. We use the number of employees dvded by 1000 (EMP). Addtonally, a dummy varable ndcates whether the frm s led by an owner or a member of the owner s famly (OWN = 1). OWN s zero otherwse. Ths dentfes the manageral frms and the mpact of managers leadershp on nnovatve performance. Moreover, we add a dummy varable f a frm contnuously performs R&D actvtes (R&D = 1). Otherwse, R&D s zero. Frms that undertake R&D permanently are expected to be more nnovatve than frms whch only occasonally carry out R&D or do not nvest n ther own R&D actvtes at all. Fnally, we take the pressure of competton nto account: ln(comp) s the log of the number of frms whch are consdered as drect compettors n the man feld of busness by the ntervewees. A hgh compettve pressure may lead to ntense nvestment nto R&D and thus to many nnovatons on the market. Of course the effect could also go nto the other drecton (Neo-Schumpeter hypothess). Overall, we use 474 observatons n the followng regresson analyses. Descrptve statstcs of the varables used are gven n Table 1. Table 1: Descrptve Statstcs (474 observatons) Varable Mean Std. Dev. Mn. Max. NewProd EMP (n thousands) R&D (contnuous actvtes) OWN ln(comp) Industry Dummes Food and Beverages Chemcals Communcaton Equpment Telecom/Computer Servces Country Dummes France Denmark Greece Netherlands Germany Unted Kngdom Italy

8 Of course, there s a relatonshp between leadershp, R&D and frm sze. The smaller frms tend to be led by the owners and several do not perform R&D on a contnuous bass. The correlaton between the number of employees and the ownershp amounts to 0.3. The frm sze and contnuous R&D actvtes exhbt a correlaton of Fnally, the correlaton between the owner and the R&D varable s Ths s no multcollnearty n the sense that t s causng techncal problems n the estmatons. Some frms dd not ntroduce new or mproved products to the market,.e. some observatons are left censored. We take ths restrcton nto account by estmatng Tobt models (cf. e.g. Greene, 1997, or Goureroux, 2000). Let the latent varable y of our econometrc model be 2 N, and * * y x, (1) where s the parameter vector to be estmated, x the vector of explanatory varables and the error term. Let the observed share of turnover wth new or mproved products be y * 0fy 0, * * y f y 0. (2) The correspondng lkelhood functon for the homoscedastc Tobt model s ( y x ) x ln L ln(2 ) ln ln 1 2 y 0 2 y 0 (3) where s the standard devaton to be estmated and ndcates the cumulatve densty functon of the standard normal dstrbuton. Frst, we estmate a homoscedastc Tobt model. However, f heteroscedastcty occurs, the homoscedastc model wll lead to nconsstent estmates for both the standard errors and the coeffcents. Therefore, based on the homoscedastc model, we compute Lagrange multpler (LM) tests on heteroscedastcty (see Greene, 1997, p. 969). Because of the results of the LM statstcs, we consder a Tobt model wth multplcatve heteroscedastcty (see Greene, 1997, p. 967). We replace wth 5 exp w (4) n the lkelhood functon (see equaton 3). w denotes the vector of varables causng heteroscedastcty and s a vector of addtonal parameters to be estmated. Intally, we ncluded EMP, ndustry dummes and country dummes n the heteroscedastcty term. However, t turned out that the country dummes have no mpact on the estmated varance and thus, we dropped them from the fnal specfcaton. The results of both the homoscedastc model and the heteroscedastc one are gven n Table 2. As the test statstcs reject the hypothess of homoscedastcty, we only dscuss the heteroscedastc model.

9 Table 2: Tobt Regresson Results (474 observatons) Dependent Varable: NewProd Homoscedastc Tobt Heteroscedastc Tobt a) Exogeneous Varables Coeffcent t-value Coeffcent t-value EMP *** *** R&D *** *** 2.77 OWN ** ** ln(comp) Industry Dummes b) - Chemcals * Communcaton Equpment *** *** Telecom/Computer Servces *** *** 8.83 Country Dummes c) - Denmark Greece Netherlands * Germany Unted Kngdom Italy Constant term *** *** 4.90 Log Lkelhood -2, , LR test on jont sgnfcance of country dummes ~ (6) d) Notes: *** report a sgnfcance level of 1%, ** of 5% and * of 10%. a) The heteroscedastc Tobt model contans ndustry dummes and EMP n the heteroscedastcty term. The estmates are not reported, but avalable upon request. b) Reference class: Food and Beverages c) Reference class: France. d) The crtcal value for rejecton of the null hypothess that all country dummes are jontly zero s (10.64) at the 5% (10%) sgnfcance level. The estmates show that frms whch are led by managers are clearly more nnovatve than others. Ths s a remarkable result as t states that leadershp of a frm does ndeed have an effect on nnovaton. The mpact of leadershp by managers s establshed for nvestment and merger actvtes but untl now not for nnovatons. The other results are nterestng as well: There are no dfferences among countres regardng the nnovatve performance of frms. The LR statstc on jont sgnfcance of the country dummes ndcates that the hypothess all country dummes are jontly zero cannot be rejected. The dummy varable whch ndcates contnuous R&D actvtes of the frm s postvely sgnfcant. Moreover, the share of turnover wth new products s decreasng wth sze. We also tested non-lnear relatonshps, but t turned out that that a lnear specfcaton of sze suffces. 6

10 Ths result s n lne wth Hansen (1992) who studed the relatonshp between the share of sales wth new products ntroduced n the recent fve years and frm sze or age. Hansen also fnds a negatve sgn for frm sze. Younger and smaller frms were more nnovatve n hs study. However, the relaton between nnovaton nput and output requres closer nvestgaton, but ths queston s beyond the scope of the present paper. The ndustry dummes report that the manufacturers of communcaton equpment as well as the telecom and computer servces are more nnovatve than the "tradtonal" ndustres of chemcal or food and beverages producton. Ths result s most lkely a reflecton of the product lfe-cycle n these ndustres. Some readers may worry about the applcaton of the Tobt model because t s a specal case of a selecton model (often called generalzed Tobt model), n whch one usually models two frm decsons. Frst, a frm has to decde whether to nnovate or not. Besdes ths propensty to nnovate, frms have to determne how much to nnovate by a second decson. The Tobt model ncorporates both decsons by assumng that the explanatory varables drvng both decsons enter the two equatons wth the same magntude. Applyng a Tobt model, we assume that there s an underlyng structural model for the unobserved varable y. However, * we only observe y > 0 f the propensty to nnovate s also larger than zero. If ths propensty s below zero, we only observe y = 0. As ths constructon of the model may seem a lttle artfcal to some people, we also estmate a fractonal response model, whch treats the dependent varable just naturally as a share whch s bound between zero and one. 4 Followng the methodology descrbed n Papke and Wooldrdge (1996), we now assume that where G s a functon satsfyng Gx E y x G x (5) 0 1. Ths ensures that all predcted values of y le between zero and one. As G we choose the cumulatve densty functon of the standard nor- x. The estmaton procedure s a partcular quas-lkelhood method mal dstrbuton: (QMLE) based on Goureroux et al. (1984) and McCullagh and Nelder (1989). The Bernoull log-lkelhood functon s gven as ln 1 ln 1 l y x y x. (6) Ths corresponds to the famlar log-lkelhood of the Probt model, except that we allow y beng contnuous n the nterval (0,1). Estmates for are obtaned from the maxmzaton problem max l N 1. Accordng to Papke and Wooldrdge, the QMLE s consstent and N -asymptotcally normal regardless of the dstrbuton of y condtonal on x.the results 4 We are grateful to an anonymous referee for the suggeston to use the QML method developed by Papke and Wooldrdge (1996) for our emprcal study. 7

11 of the estmaton are dsplayed n Table 3. The standard errors are computed robust as suggested n Papke and Wooldrdge (1996, p ) to obtan the true asymptotc varance. Note, that n the Tobt estmates Newprod has been measured n percentage ponts,.e. n the nterval (0,100), but for the estmaton of the fractonal response model we have rescaled t to the nterval (0,1). Table 3: QMLE results of the model for a fractonal response varable (474 obs.) Dependent Varable: NewProd Exogeneous Varables Coeffcent z-value EMP -.47 *** R&D.26 *** 3.38 OWN -.17 ** ln(comp) Industry Dummes b) - Chemcals.17 * Communcaton Equpment.62 *** Telecom/Computer Servces.73 *** 8.35 Country Dummes c) - Denmark Greece Netherlands -.20 * Germany Unted Kngdom Italy Constant term -.73 *** Quas Log Lkelhood Notes: *** report a sgnfcance level of 1%, ** of 5% and * of 10%. b) Reference class: Food and Beverages c) Reference class: France. We have also carred out a general functonal form dagnostc to check for possble unobserved heterogenety n the model. Ths test s an extenson of the RESET procedure to ndex models and s descrbed on page 625 n the paper of Papke and Wooldrdge. We test whether quadratc and cubc terms of x cause a rejecton of our model specfcaton as gven n 2 equaton (5). We compute the robust LM statstc whch s dstrbuted wth two degrees of freedom. The value of the LM statstc n our case s 1.65 (p-value = 0.44) whch means that our specfcaton as presented n Table 3 passes the test and, thus, does not need to be rejected. The results reveal those of the Tobt models: Owner-led frms have sgnfcantly smaller shares of sales wth new products than manager-led companes. The share of nnovatve sales s negatvely related to frm sze. Frms that engage permanently n R&D actvtes reach 8

12 larger shares of sales wth product nnovatons. Agan, we fnd sgnfcant dfferences among ndustres but not among countres. 4 Conclusons We present the results of an emprcal study on the nnovaton actvtes of European frms. Our dependent varable s the share of sales, whch can be attrbuted to newly developed products. Both Tobt regressons and a quas maxmum lkelhood estmator for models of a fractonal response varable pont to the same concluson: It turns out, that manageral led frms have a larger share than the other frms. Ths s mportant emprcal evdence concernng the effects of leadershp on the behavor of frms. Whle the mpact of managers has been dscussed n other connectons, t has been neglected wth respect to nnovaton. A welfare theoretc evaluaton of ths result s controversal. Economsts usually favour the vew that the captal owners are most knowledgeable regardng what has to be done to maxmze profts and therefore they wll nvest the proft-maxmzng amount of R&D. Ths n turn mples that the manageral frms nvest too much f proft maxmzaton s the am. However, nnovatons have strong spll-over effects to other frms and these postve externaltes may change the evaluaton of nnovatve actvty from a socal pont of vew. Wth these externaltes n mnd, owner-led frms may nvest too lttle nto nnovaton whle managers are closer to the socal optmum. However, they do ths n order to maxmze ther own nterests and do not thnk about a socally desrable level of nnovaton and, hence, t would be pure concdence f the socal optmum of nnovaton s reached. 9

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