INNOVATION CAPABILITY AND FIRM PERFORMANCE HETEROGENEITY IN THE SMALL AND MEDIUM SIZED ENTERPRISE SECTOR

Transcription

1 INNOVATION CAPABILITY AND FIRM PERFORMANCE HETEROGENEITY IN THE SMALL AND MEDIUM SIZED ENTERPRISE SECTOR BY SUNG SUP KIM DISSERTATION Submtted n partal fulfllment of the requrements for the degree of Doctor of Phlosophy n Economcs n the Graduate College of the Unversty of Illnos at Urbana-Champagn, 2013 Urbana, Illnos Doctoral Commttee: Professor George Deltas, Char and Drector of Research Professor Anl K. Bera Assocate Professor Seung-Hyun Hong Vstng Assstant Professor Evangela Chalot

2 ABSTRACT Ths study attempts to fnd emprcal evdence for the effect of frm-level nnovatve actvty as a new source of frm performance heterogenety. It also proposes several nnovaton ndcators that measure a frm s capablty to nnovate so as to help understand the nnovaton of small medum szed enterprse (SME) as a contrbutor to frm productvty. In ths study, I propose and estmate a structural model contanng the lnk between nnovatve actvtes and frm performance measured by labor productvty. I try to modfy the basc dea and specfcaton of the econometrc model suggested by Crépon, Duguet and Maresse (1998) n order to apply some unque features of SMEs and to use the data from the Korean Innovaton Survey (KIS) admnstered accordng to OECD gudelnes. The frst and second chapter provdes the theoretcal foundaton and analyss relevant to the process of nnovaton wthn SMEs to support the econometrc model that contans the relatons among nnovaton nput, nnovaton output and productvty. The conceptual establshment of the nnovaton process wthn a frm s formalzed as an nput-output system where knowledge captal as an ntermedate output of frm-level nnovatve actvtes s hypotheszed to contrbute to enhancng labor productvty through the Constant Elastcty of Substtuton (CES) producton functon. The thrd chapter ntroduces the econometrc system equatons whch descrbe the whole nnovaton process of a frm from the ntal stage of engagement n nnovatve actvtes to the fnal stage of producton and performance. In each stage, the system equatons are estmated sequentally n a fashon to avod the smultanety and selecton bas whch arse

3 from the fact that a dependent varable from a prevous stage s ncorporated as an explanatory varable at the next stage. The results of the estmaton show that the probablty of havng each type of nnovaton output ncreases. Investments n nnovaton, nnovaton output and labor productvty are all postvely related wth each other n the SME sector, and those relatons vary by ndustry, frm sze, area and cohort. One nterestng pont n those results s that the more export-orented and government-supported a frm s, the more lkely t s to partcpate n nnovatve actvtes. An extended explanaton of these ssues requres more n-depth study related to polcy measures of governments and should be the focus of future work. These emprcal fndngs lead us to roughly conclude that nnovatve actvtes could be regarded as another mportant factor affectng frm-level heterogenety n productvty. It should be noted, however, that although ths result reveals some underlyng connectons of nnovatve actvty to performance, t does not provde any detaled nformaton about the nnovatng capablty of each frm, whch also plays a sgnfcant role as a determnant of productvty. Thus, t s necessary to measure frm-level nnovaton capablty n order to predct the possblty of future growth for a frm to the extent that nnovatve actvtes contrbute to another mportant factor determnng frm-level performance. In the fourth chapter, I develop several possble nnovaton ndcators that measure nnovaton capablty of a frm n an econometrc way. Based on the bnary responses to each type of nnovaton and other related nformaton provded by the Korean Innovaton Survey (KIS) 2008 Manufacturng, the underlyng factors that affect the nputs and outputs of the

4 nnovaton process are extracted from a tradtonal factor analyss. They help establsh two dfferent knds of models: the Latent Trat (Factor) Model (LTM) and the Multvarate Probt Factor Model (MVPFM), and consequently construct several nnovaton ndcators that represent frm-level nnovaton capabltes across ndustres and szes of frms. Innovaton ndctors 1 & 2, constructed by the LTM, represent the weghted scores of common factors that underle four bnary nnovaton outputs and two bnary nnovaton nputs from the KIS 2008 Manufacturng. Innovaton ndctors 3 & 4, constructed by the MVPFM, represent the expected probabltes of beng engaged n nnovaton nputs and outputs. Some plausblty tests for the LTM are mplemented to support the ftness of the proposed model to other smlar data, confrmng the valdty of the proposed ndcators. A second plausblty test s mplemented by makng a comparson to the ndustry and sze dstrbuton of Korean nnovatve SMEs certfed by the Korean government. The ndustry and sze dstrbuton of SMEs at or above the 85 th percentle of the proposed nnovaton ndcators n the KIS 2008 Manufacturng have a smlar pattern to Korean nnovatve SMEs, mplyng that ndcators proposed n ths study could be appled as a self-dagnostc tool for the nnovaton capablty of a frm. v

5 To my parents and famly v

6 ACKNOWLEDGEMENTS Ths paper would not have been possble wthout the support of many people. My frst and sncere thanks should go to my advsor, Professor George Deltas. If t had not been for hs gudance and encouragement, I could not have arrved here successfully at ths destnaton. Many thanks to the rest of my dssertaton commttee, Professor Anl K. Bera, Professor Seung-Hyun Hong and Professor Evangela Chalot for ther valuable comments and advce. Ths paper also could not have been completed successfully wthout the help of the data from the Scence and Technology Polcy Insttute (STEPI) of Korea. As always, I am deeply grateful to my lovng famly: Hae-Jung, Chels, Jenny and Andrew. They have always been accompaned and supported me, enablng me to experence the pleasure of study throughout ths long journey. v

7 TABLE OF CONTENTS CHAPTER 1: GENERAL INTRODUCTION Innovaton as a new source of economc performance of SMEs Frm-level nnovaton and ts measurement Measurng the nnovaton capablty of SMEs Major research focus of ths study...9 Chapter 1 Tables and Fgures CHAPTER 2: THE EFFECT OF INNOVATION ON FIRM PERFORMANCE: THEORETICAL CONSIDERATIONS AND EMPIRICAL FINDINGS Conceptual framework of the nnovaton process of SMEs Theoretcal background of the effect of nnovaton capablty on frm performance Baselne model of frm nnovaton and performance relaton Prevous emprcal approaches and major fndngs Chapter 2 Tables and Fgures CHAPTER 3: INNOVATIVE ACTIVITY AS A DETERMINANT OF PERFORMANCE HETEROGENEITY: EMPIRICAL EVIDENCE FROM KOREAN SMEs Introducton The econometrc model: Frm-level nnovatve actvty and productvty lnk Model specfcatons and estmaton Data Emprcal results Implcaton and dscusson Chapter 3 Tables and Fgures v

8 CHAPTER 4: TOWARD MEASURING FIRM-LEVEL INNOVATION CAPABILITY WITH COMPOSITE INDICATORS Introducton Revew of the prevous lterature The econometrc model Data and estmaton Indcators for nnovaton capablty Econometrc results Plausblty tests Implcaton and dscusson Chapter 4 Tables and Fgures CHAPTER 5: CONCLUSION APPENDIX A REFERENCES v

9 CHAPTER 1 GENERAL INTRODUCTION The world economy has recently seen a dsmantlng process of tangble or ntangble barrers among natons and an acceleraton of the free movement of producton factors such as labor and captal resultng from a rapd progresson toward globalzaton. Snce the late 1990s, the global busness envronment has rapdly changed, seeng a movement of the busness competton fashon from comparatve advantage of tradtonal factors such as labor and captal to ntangble knowledge-based economc factors based on the creaton and utlzaton of knowledge captal and nformaton. The busness and economc envronments of small and medum szed enterprses (SMEs) are no excepton. As ponted out by Acs and Audretsch (1990), the ncreasng tendency of globalzaton has resulted n a growng number of foregn compettors, whch has rendered global markets a place where corporatons/busnesses must fght to reman n exstence. Productve, manageral and organzatonal flexblty, whch are n fact more valuable assets n response to volatle busness envronments, tend to be more effectve for smaller szed frms than larger ones n ths stuaton. One prevalent assumpton about frm sze and technology has been that technologcal change or techncal progress s brought about by large amounts of R&D resources organzed by large-szed corporatons. Under ths growng trend of global busness competton, however, SMEs and ther nnovatons, beng poneers explorng new market profts, are thus ncreasngly 1

10 pad attenton to as an mportant focus of economc polcy-makng n OECD countres. Ths s partcularly true for most countres n OECD regons where SMEs enlarge ther role of confgurng the economc base of knowledge-based economes. Even more, most new employment s absorbed n the newly growng SME sectors nstead of large companes that have only a small porton of employment n those economes. As Brch (1981) dscovered from hs long-term study of job creaton n the U.S., large frms were no longer major creators of new jobs. Neumark, Wall and Zhang (2008) also demonstrated that most new jobs were from small-szed frms n the U.S. Ths s also true for most other OECD countres (OECD, 2005b). It s thus not surprsng that many countres wthn the OECD are tryng to ncrease R&D subsdes or governmental support for hghly nnovatve SMEs and expand nnovaton related nformaton for SMEs to mprove ther potental for nnovaton Innovaton as a new source of economc performance of SMEs The growng nterest n the nnovaton of SMEs from an economc growth perspectve stems from a seres of dscussons about the effect of technologcal progress on economc growth, such as the poneerng study of economc growth by Solow (1957), and more recently, 1 Durng the second OECD Mnsteral Meetng for SMEs held n June 2004, representatves from many developed countres evaluated polcy prortes for enhancng the potental contrbuton from nnovatve SMEs n order to mprove economc performance n terms of ncreased employment absorpton and productvty growth. They pronounced the promoton of start-ups and the voluntary nnovaton of SME sectors as the core economc polces that governments should undertake n the future. 2

11 the study of Amercan economc growth by Denson (1985). After Solow suggested a framework for estmatng productvty resdual that could be attrbuted to effcent use of nputs, most studes recognzed technologcal progress or nnovatve actvtes as one of the resdual factors that could explan the remanng sources of economc growth (Maresse and Sassenou, 1991; Lchtenberg and Segel, 1991). In ths sense, lookng at the dfference n labor productvty levels across OECD countres, as presented n Fgure 1.1, re-nvtes a tradtonal queston about the new source of productvty heterogenety across countres. Combnng Table 1.1 and Fgure 1.2, one can see a new and nterestng trend that some of the countres wth hgh employment absorpton and outputs by small and medum szed frms tend to reveal low levels of GDP per hour worked. Ths trend n turn mples that productvty heterogenety n the SME sector could play a crucal role n makng a dfference n labor productvty at the natonal level, to the extent that they account for a large porton of employment absorpton and outputs, and thus make an economc base for the producton chan (supply chan) or economc actvty wthn those countres. Despte the promnent status of SME s contrbutons to the whole economc actvty n most OECD countres, prevous emprcal studes on R&D, techncal change and productvty have concentrated on large frms, or at least have not consdered varaton by frm sze (Acs and Audretsch, 1988; Grlches, 1998). The study of SMEs nnovaton and ther effects on frm performance thus seems to reman undeveloped n economc lterature 2 although a recently 2 Ths has mostly been a result of the lack of avalable data collected for the purpose of SMEs. However, the progress of collectng data on frm-level nnovaton and the progress of measurement of nnovaton nputs and outputs have enabled economsts to broaden the realm of study related to the effect of nnovaton n SME sectors. 3

12 growng body of emprcal evdence ndcates that SMEs play an ncreasngly mportant role n technologcal change (Acs and Audretsch, 1990). Most of the emprcal studes regardng the sources of productvty (or productvty growth) largely show that the growth of labor and captal nputs account for less than half of the growth of productvty n the U.S. and other countres (Hall, 2011). In addton, they try to fnd the approprate measures that account for the unexplaned porton of productvty and attempt to obtan economc evdence on the postve relaton between R&D and productvty (Grlches, 1998). Drven by growng nterest n the remanng sources of productvty growth other than the contrbuton of labor and captal, many studes were conducted on the relaton between nnovatve actvtes and productvty. R&D actvtes (or expendture on R&D) or patent counts have been used to explore those remanders, although those measures have both postve and negatve mpacts on economc performance (Hall, 2011). 1.2 Frm-level nnovaton and ts measurement Academc concepts and theores of nnovaton n busness and economcs are mostly nfluenced by the poneerng work of Joseph A. Schumpeter. Schumpeter (1934) dstngushed fve dfferent types of nnovaton: 1) ntroducton of new products or qualtatve changes n exstng products, 2) ntroducton of new ways or methods of producton or substantal changes n exstng ones, 3) openng of new markets, 4) development of new sources of supply or use of new sources for obtanng raw materals and other nputs, and 5) new ways to organze 4

13 busness. Innovaton s dstngushed from nventon n the sense that nventon s the frst ntroducton of a new dea for a product or process, whle nnovaton s the frst attempt to put a new product or process nto commercalzaton. Those two concepts are, n realty, closely related each other to the extent that t s not easy to clearly dfferentate them (Fagerberg, Mowery and Nelson, 2005). A seres of works by the OECD and others helped researchers agree upon an emprcally acceptable defnton of frm-level nnovaton, contaned n the Oslo Manual (OECD, 2005a) 3, across countres and busnesses: an nnovaton s the mplementaton of a new or sgnfcantly mproved product (good or servce), or process, a new marketng method, or a new organzatonal method n busness practces, workplace organzaton or external relatons (p.46). The Oslo Manual dstngushes four dfferent types of frm-level nnovaton such as product nnovaton, process nnovaton, organzatonal nnovaton and marketng nnovaton 4. The U.S. Department of Commerce (U.S. DOC) also defnes nnovaton smlarly: the desgn, nventon, development and/or mplementaton of new or altered products, servces, processes, organzatonal structures, and busness models for the purpose of creatng new value for 3 The Oslo Manual was frst provded as an nternatonal gudelne n 1992 to help effcently collect and nterpret nnovaton survey data from frms and to develop polces that support frm nnovaton approprately. It provdes basc defntons of nnovaton at the frm-level and dvdes nnovaton nto four dfferent sub-types of actvtes such as product nnovaton, process nnovaton, organzatonal nnovaton and marketng nnovaton. 4 The Oslo Manual defnes a product nnovaton as actvtes related to the ntroducton of a good or servce that has new or technologcally mproved specfcatons, components and materals or other functonal characterstcs; a process nnovaton as the mplementaton of a new or sgnfcantly mproved producton and/or delvery method; an organzatonal nnovaton as the mplementaton of a new method n a frm s organzaton, busness practces, work place or external relaton; and a marketng nnovaton as the mplementaton of a new method of marketng whch typcally accompanes sgnfcant changes n product desgn, packagng, placement, promoton or prcng. 5

14 customers and fnancal returns for the frm (U.S. DOC, 2008, page ) 5. Whle both of the two defntons recognze that nnovaton does not only mply somethng new, the latter emphaszes the addtonal concept of addng value for both customers and frms. The complete defnton of nnovaton by the DOC can support the emprcal construct of frm-level nnovaton capablty dscussed n CHAPTER 4. Before usng survey data about varous aspects of frm-level nnovaton to dsclose the effect of nnovaton on frm performance, a large porton of prevous studes tred to measure nnovaton usng R&D actvty (or accumulated R&D captal) as a proxy of nnovaton (Hall, Maresse and Mohnen, 2010). Patent counts were also consdered as vald economc ndcator of nnovaton output n spte of ts nherent weakness (Grlches, 1990). After the frst ntroducton of the Oslo Manual n , however, many countres wthn OECD regons have admnstered perodcal cross-sectonal Communty Innovaton Surveys (CIS), whch attempt to capture frm-level nformaton related to: 1) a varety of nnovatve actvtes not lmted to formal R&D expendture, such as applyng patents, personal job tranng, product analyss, market penetraton, 2) possble ndcators related to varous knds of nnovaton outputs such as percentage of sales from new products, the number of nnovatons mplemented durng gven perod, and 3) the way a frm mplements nnovaton, such as sources of nnovaton-related knowledge, obstacles to nnovaton, outsde nnovaton partnershp and so on. The extensve use of frm-level data, along wth the progress of 5 Ths s not an offcal defnton of nnovaton by the DOC, but one adopted by the Advsory Commttee of the U.S. DOC. 6 Ths gudelne, jontly proposed by the OECD and Eurostat, s concerned wth the collecton and the nterpretaton of nnovaton data at the level of the frm. 6

15 measurng nnovatve actvty after the ntroducton of gudelnes for collectng and nterpretng data on busness frm-level nnovatve actvty, made t possble to conduct ths knd of research n a broader perspectve. As ponted out by Maresse and Mohnen (2010), t s true that data from CISs greatly helped dentfy nnovaton measures that provde both qualtatve and quanttatve nformaton about nnovatve actvtes ncludng non-formal R&D and the successful ntroducton of varous types of nnovaton wthn a frm. 1.3 Measurng the nnovaton capablty of SMEs Due to the progress of measurng nnovaton wthn a frm and growng concerns about the role of SMEs n new employment and value creaton, nnovatve SMEs 7 whch are able to create new value and employment through nnovaton, are now drawng attentons n both developng and developed countres (OECD, 2005a). They seek contnuous nnovaton n technology (R&D) and management and create new value, gong beyond the quanttatve growth strategy. They have also been shown to respond effectvely to potental future changes n the busness envronment, and they have created areas of hgh value va busness allances, cooperaton and specalzaton n varous areas of producton and management. Two remanng questons are then how can we measure the nnovaton capablty of SMEs and how can we dfferentate nnovatve SMEs, that s, SMEs wth nnovaton capablty, 7 An nnovatve frm s bascally defned as one that creates new value and employment through one of the nnovaton-related actvtes such as product nnovaton, process nnovaton, organzatonal nnovaton and marketng nnovaton (OECD, 2005a). 7

16 from ther non-nnovatve counterparts. Accordng to Romjn and Albaladejo (2002), nnovaton capablty refers to the accumulated ablty to mprove exstng technology and to create new technology resultng from the varous nternal and external sources. Appled to products, processes, organzatonal and marketng nnovatons, respectvely or combned, t s presumed to expand a frm s overall capablty to ntate and keep up wth technologcal changes (Romjn and Albaladejo, 2002). Evaluatng and measurng nnovaton capablty, however, rases several ssues related to the use of approprate measures or ndcators. Academc studes on the evaluaton of frm-level nnovaton capablty thus far have tred to develop a concept of nnovaton capablty whch ntegrates nternal and external resources as well as to fnd the determnants of t. A seres of these efforts of establshng nnovaton capablty, however, have nevtably admtted to lmted applcablty due to the lack of usable data that contan a varety of nnovaton-related nformaton before the development of CIS type nnovaton surveys. Apart from academc efforts to gauge a frm s nnovaton capablty, some evaluaton models of frm nnovaton, created by governments to determne whether a frm s nnovatve or not, have been developed and mplemented for polcy purposes to promote naton-wde frm-level nnovatons. The Innovaton Capablty Indcators for Innovatve Busness created by the Korean government s one example. Ths method, though precse and consstent, reveal the weaknesses that hamper convenent use and self-dagnoss for SMEs: They requre a closer look at a frm s nnovatve actvtes, broad ntervews wth managers, and tme- and cost-consumng examnatons of the resources of a frm by traned experts. Thus, t would be more useful to the 8

17 frms that try to be more nnovatve f frm-level nnovatve actvtes and ts capablty to nnovate could be measured and evaluated n a more complcated but convenent way. 1.4 Major research focus of ths study Ths study s an analytcal attempt to nvestgate the nnovaton-related actvtes takng place wthn SMEs and the effects of those on frm performance. The man focus of ths study s thus to shed lght on how much a varety of outcomes from those actvtes wthn the doman of a frm affect a frm s performance heterogenety to the extent that those actvtes can explan the remanng sources of frm performance. The emprcal analyss usng frm-level nnovaton survey data, presented n CHAPTER 3, helps uncover new factors affectng the remanng sources of frm performance, and addtonally, adds another country-specfc fndng to the growng body of emprcal evdence nvestgatng the relatonshp between an SME s nnovaton and frm performance. Another mportant objectve of ths research s to develop and suggest an econometrc method to measure and evaluate frm-level nnovatveness or nnovaton capablty, whch s presumed to have a sgnfcant (or at least potental) mpact on frm performance, as dscussed n Secton 1.3. An evaluaton of the frm-level capablty to carry out nnovaton could be helpful to researchers and analysts tryng to obtan a bg pcture of understandng nnovatng frms across ndustres, and mght be able to advse possble polcy measures to enhance naton-wde nnovaton, to the extent that nnovaton has a sgnfcant mpact on the long-term performance 9

18 growth of frms. In CHAPTER 4, several ndcators wth whch one could accomplsh those goals along wth several smple ndcators wll be suggested along wth ther nterpretatons from an emprcal analyss on survey data. Fnally, some possble test methods are employed to ensure the valdty of those suggested evaluaton tools. 10

19 Chapter 1 Tables and Fgures Table 1.1 Dstrbuton of output by frm sze n manufacturng sector (OECD, 2005b) (n percent) Country Australa Austra Belgum Denmark Fnland France Germany Greece 1) Ireland Italy Japan New Zealand Norway Portugal Span Unted Kngdom Unted States 2) ) Output of Greece has the followng frm sze bands: 1-9, 10-49, , ) Output for U.S. has the followng frm sze bands: 1-9, 10-99, , ) Source: OECD, Statstcs on Enterprses by Sze Class Database 11

20 Fgure 1.1 GDP per hour worked of the OECD countres (2010) (Current prce n US Dollar) OECD average Source: OECD StatExtracts 12

21 Fgure 1.2 Total employment absorpton by frm sze (OECD 2002, Manufacturng sector) Source: OECD SME and SS Source: OECD, SME and Entrepreneurshp Outlook

22 CHAPTER 2 THE EFFECT OF INNOVATION ON FIRM PERFORMANCE: THEORETICAL CONSIDERATIONS AND EMPIRICAL FINDINGS 2.1 Conceptual framework of the nnovaton process of SMEs SMEs are, as ponted out by much of the lterature, consdered to be the engne of technology mprovement and nnovatve actvty, at least n certan ndustres (Acs and Audretsch, 1988). Innovaton by SMEs, however, has some unque features that most tradtonal ndcators of nnovatve actvty cannot capture, ncurrng the rsk of underestmatng ther nnovaton efforts (Hall, Lott and Maresse, 2009). The nnovatve actvtes of SMEs are not lmted to formal forms of R&D, but often occur through numerous channels. As mentoned n Hoffman, Parejo, Bessant and Perren (1998), despte the large number of government polcy measures desgned to promote and support nnovatve actvtes wthn SMEs, understandng the way SMEs actually engage n nnovatve actvtes remans qute lmted, causng possble bas n emprcal studes of the relaton among R&D, nnovaton and ts performance. The behavoral process of nnovaton wthn SMEs, n partcular, has dstngushng features dfferent from those that are generally seen n larger frms. The classfcaton by Jeon, Nagasaka, Son, Wang, Ahn and Lee (2000), for example, presents the pecularty of SME nnovaton: 1) an mplementaton of nnovaton pursung socety s recognton, 2) an emphass 14

23 on the mportance of communcaton, 3) the settng of ambtous goals, 4) a non-rgd performance measurement system, and 5) a preference for operatonal effcency pursung domestc markets. They suggest that, for more hgher performance SMEs would need to 1) mplement process-orented nnovaton for the capablty buldng of ndvduals and the organzaton, 2) nvolve all the employees by enablng them to dentfy ther own tasks, 3) allow employees to determne ther own levels and choose the rght methods accordng to ther levels, and lastly, 4) pursue nnovaton not partally, but entrely. The conceptual framework of the nnovaton process was frst ntroduced and developed n detal by Gruber and Marqus (1969). It s consdered to occur n three overlappng phases or sub-processes: dea generaton, problem solvng and mplementaton followed by dea dffuson, and broadly emboded n poltcal, socal, and economc envronments classfed by Utterback (1971). Atherton and Hannon (2000) also suggest four man stages of the nnovaton process wthn SMEs: buldng blocks of nnovaton strategy, development of nnovatve responses to external threats and opportuntes, strategc commercalzaton of nnovatve responses to maxmze benefts, and lastly, frm outcomes and performance. The nnovaton process of SMEs s accordngly consdered as an nternal actvty that makes t possble to create new products and servces or modfy them to respond to the new demands of a market. Accordng to hs four staged model, an effectve nnovaton reles on managng the whole process where a frm bulds up capacty and competency. The applcable framework of the SME s nnovaton process n ths study bascally rests on the perspectves of resource-based process and capablty, n the sense that t assumes that 15

24 the frm performance dfferentals are nfluenced by the way a frm manages ts capablty and resources, or by what s defned as one knd of nnovatve actvty. Even more, the above phased frameworks of the nnovaton process above also contrbute to a useful nput-output approach to nnovatve actvtes whch take place wthn a frm from an operatonal perspectve smlarly seen n Bolnao (2009). The operatonal nput-output model for estmaton purposes (see Fgure 2.1) can thus be establshed wth three sets of varables: 1) ndependent nput varables whch are related to the envronment ncludng strateges of nnovaton, resources and the capablty to nnovate, 2) ntermedate varables related to the mplementaton of nnovaton, and lastly, 3) dependent output varables such as nnovaton outputs and frm performance. Three groups of varables wthn the above framework are thus consdered to nteractvely affect the performance of a frm throughout the whole process of nnovaton. 2.2 Theoretcal background of the effect of nnovaton capablty on frm performance As dscussed n CHAPTER 1, nnovaton capablty, defned as the potental of a frm to generate nnovatve output, s a crtcal element to frm performance n a hghly compettve economc envronment snce frm-level capablty to nnovate has a drect nfluence on compettveness at the frm-level. Squera and Cosh (2008) tred to examne the mportance of a frm s capablty to mplement nnovaton n order to explan the compettve advantage of a frm (especally SMEs). The framework of that study s based on the resource-based theory n busness economcs and management lterature, whch s more concerned wth the relatonshp 16

25 between nnovaton and nternal resources of frms. The resource-based theory clams that the performance heterogenety across frms s, to a great extent, attrbuted to frm-specfc resources and capabltes, whch not only form the prmary source of proft for a frm, but also provde the fundamental gudelnes for a frm s strategy (Conner, 1991). In ths theory, resources and capabltes are assumed to play the followng roles: the foundaton for frm strategy, the source of busness drecton and the proftablty of a frm (Grant, 1991). It also focuses on how frm performance and compettve advantage are affected by the management of organzatonal resources and capabltes through nnovaton (Schulze, 1994). The next queston then mght be how nnovaton capablty s drectly or ndrectly assocated wth frm performance heterogenety. The nnovaton capablty of a frm, n lne wth the defnton of nnovaton, can also be sourced from a varety of nnovatve actvtes such as product nnovaton, process nnovaton, organzatonal nnovaton and marketng nnovaton. Emphaszed by Gerosk and Machne (1992), the ntroducton of new products enables a frm to strengthen ts market power relatve to ts compettors. In addton, process nnovaton makes t possble to drastcally transform a frm by enhancng ts nternal capablty to make t more flexble to market demand and more adaptable to change n the market envronment where t does busness. Gerosk and Machne suggested that under certan crcumstances, process nnovaton s much more mportant than product nnovaton as a determnant of the frm performance dfferental between nnovatng frms and non-nnovatng frms. Several prevous studes have found that certan organzatonal structures or changes n 17

26 organzaton could accelerate the creaton of new deas and products or the ntroducton of new processes n a rapdly changng economc envronment (Teece, 1998). Compared wth technology-based nnovaton (product nnovaton and process nnovaton), t s true that the relatonshp between organzaton and nnovaton appears complex, dynamc and even ambguous snce the term organzatonal nnovaton has no fully agreed defnton (Fagerberg et al., 2005). However, followng the clam by Penrose (1957) that the technologcal compettveness of a frm, whch n turn mples a capablty to nnovate, derves from the cumulatve and ncremental learnng experence of ts organzaton and management, the dstnctveness of the frm s cumulatve knowledge from organzatonal experence can determne the potental to seze future opportuntes before compettors. The potental of a frm to outperform n the future, often defned as compettveness, comes from dfferentated capablty to mantan long-term growth and thus survve the turbulent economc envronment. As ponted out by Cantwell (2005) and other economsts, such potental capabltes, vared and dfferentated across frms, are sourced and generated by contnuous nnovatve actvtes. 2.3 Baselne model of frm nnovaton and performance relaton Economc studes that try to measure the contrbuton of frm-level nnovatons to economc performance mostly rely on prevous conceptual frameworks n whch frm-level R&D actvty and ts productvty are closely connected. Ths framework can now be formalzed by 18

27 the followng producton functon, F connectng measure of output (actual total sales or value-added), Q to the nputs X, K and u where X represents measures of conventonal nputs such as labor and captal, K measure technologcal knowledge and u stands for other undentfed determnants: (2-1) Q F( X, K, u ) t t t t If a measure of the current state of technologcal knowledge s assumed to be related to the past and current R&D actvtes 8, separated by conventonal nputs (that s, captal and labor), what matters s how to choose a specfc form of the producton functon employed n the followng analyses. Most of the prevous studes on those relatons employed the smple Cobb-Douglas producton functon, descrbed below, as ther analytcal functonal forms (Maresse and Sassenou, 1991; Grlches, 1998; Hall, 2011). The Cobb-Douglas specfcaton of producton technology has several advantages n ths knd of analyss because t has the followng useful features: 1) t has a smple, functonal form of trans-logs and the coeffcent of each varable n ths specfcaton drectly represents the rate of return to each varable, 2) t s easy to estmate enough parameters wth a lmted use of the survey data, and 3) n the Cobb-Douglas specfcaton, t s possble to relate productvty to knowledge captal substtuted 8 Grlches (1998) proposed a lnear relaton between past and current levels of R&D and techncal knowledge, K G[ W( B) R, v], where W( B) R w0 Rt w1 Rt 1 w2 Rt 2 and R s are the R&D levels at each tme perod and v s another unmeasured factor. 19

28 by R&D ntensty (defned as the rato of R&D expendture to total sales) wthout drect measurement of knowledge captal stock (see Appendx A). Despte the usefulness of the Cobb-Douglas specfcaton, t does not seem to provde a better approxmaton of the relaton between nputs and output than the Constant Elastcty of Substtuton (CES) producton functon by Arrow, Chenery, Mnhas and Solow (1961), the most acceptable choce n economc analyss. Ths study, dfferent from the prevous attempts, employs the specfcaton of a smple homogenous CES producton functon wth three factors as a specfc form of the producton functon, F. Then the specfc form of F n Equaton (2-1) can be rewrtten as: (2-2) u Q D [ C L K ] e where captal; L s a measure of labor (often the number of employees); C s a measure of physcal K refers to a measure of the current amount of knowledge captal stock, partly determned by current and past expendture on nnovatve actvtes such as R&D and non-r&d actvtes; D denotes frm-specfc total factor productvty whch s constant; 1, 2 and 3, whch are to be estmated under the condton of , are the share parameters of physcal captal, labor and knowledge captal, respectvely; refers to the substtuton parameter whereas 1 gves the elastcty of substtuton and must be greater than 1 20

29 or equal to -1; s the rate of dsemboded techncal change over tme; u represent the error terms reflectng systematc components of the unmeasured factors; and lastly, denotes the ndvdual frm (or the entty). Note that n the above basc CES framework, the producton technology s lmted to specfy equal elastctes of substtuton ( ) among all nput factors. One can further rewrte Equaton (2-2) n terms of labor productvty, that s: (2-3) 1 D Q C K u [ ( ) ( ) ] e L L L For estmaton purposes, Equaton (2-3) can be re-expressed n terms of logarthms of varables as shown n the followng non-lnear equaton: 1 (2-4) ln[ q l d 1 c 2 3 k ] u where q, l and d denote the value of correspondng upper case varables n a logarthm, and c and k denote per capta physcal captal and knowledge captal, respectvely. To apply ths equaton to survey data, one mght need to fnd an approprate measure of per capta knowledge captal ( k ) to avod the measurement ssue arsng from the fact that t s dffcult to properly measure K usng the nnovaton survey data. Knowledge captal 21

30 ntroduced by Pakes and Grlches (1984) can be consdered as accumulated knowledge related to producton processes wthn a frm from varous frm-level nnovatve actvtes. Measures of nnovaton outputs such as nnovatve sales and patents from a frm-level nnovaton process would play a meanngful role as a proxy n Equaton (2-4). The estmaton of each parameter, however, would requre some necessary assumpton such as compettve nput factor markets or output market structure, whch mples that each estmated coeffcent represents the exact porton of revenue assgned to each nput factor. Furthermore, t assumes that these coeffcents are constant across the frms n the sample so as to be estmated by a regresson method (Hall, 2011). Ths study s thereby more nterested n estmatng the coeffcent of knowledge captal wthn the above CES producton functon framework on the condton that the output level Q and knowledge captal stock K are measured and specfed n a precse fashon. The sgn and magntude of the coeffcents may help us gan evdence regardng the role of nnovaton n frm-level performance. 2.4 Prevous emprcal approaches and major fndngs After Schumpeter s (1934) classc dscusson 9 relatng to the role of large monopolstc frms n technology advancement or nnovaton, numerous emprcal studes on the 9 Cohen (2010) suggested that Schumpeter ponted out the fundamental dfferences of nnovatve actvtes between small frms and large ones wth formal enttes that conduct R&D actvtes, whle Nelson, Peck and Kalachek (1967) understood those clams n the sense that R&D actvtes are largely mplemented by large corporatons wth formal laboratores, whch have been a major source of nnovaton n captalstc socetes. 22

31 determnant have been conducted and the hypotheses about the effect of frm sze, market structure on frm-level nnovaton n Schumpeteran tradton have been establshed and tested usng regresson methods. A few peces of evdence justfyng the postve effect of frm sze on nnovaton have been presented n those studes 10. Followng ths tradton, more recent emprcal analyses based on the frm-level data of varous countres 11 have tred to reveal the determnants of frm performance. Dependng on the augmented producton functon wth nnovaton as another nput, they revealed that R&D nvestment and patent counts, despte ther weakness as a measure of nnovaton n that they do not capture all the aspects of frm-level nnovaton, have a postve mpact on frm-level productvty (Grlches 1995). Nevertheless, t s generally agreed upon that varous knds of nnovatve actvtes wthn the doman of a frm could not be captured by those sngle measures ncorporated n the regressons, and therefore, t s possble to underestmate the effect of nnovatve actvtes on performance wth those measures, partcularly n SME cases. In order to avod ths problem, the followng studes have modfed the tradtonal approach; they consdered nnovaton as an output wthn a frm s producton process rather than an nput, by ncludng the outcome of the nnovaton n the regresson equaton as dependent varable (Crépon, Duguet and Maresse, 1998; Hall et al., 2009). Ths could be another way to overcome the dffculty n measurng the nnovatve efforts of frms due to the presence of numerous unobservable factors, and 10 For more detals, see Cohen (2010). 11 For the U.S., see Lchtenberg and Segel (1991), France see Crépon, Duguet and Maresse (1998), Sweden see Lööf and Heshmat (2002), Italy see Hall, Lott and Maresse (2009) etc. 23

32 therefore, ths allows us to pay more attenton to the output of nnovaton such as number of patents, sales of products newly ntroduced to the market and so on (Hall et al., 2009). After Grlches (1979) frst suggested a framework for the analyss of nnovaton and productvty growth that ncorporated the relaton between R&D nvestment and the output of nnovaton, a varety of emprcal models representng those relatons were provded. More recently, Crépon et al. (1998) developed a useful emprcal model (hereafter CDM model) for estmaton, whch establshed the relaton among R&D nput (not lmted to formal R&D argument), nnovaton output and productvty, combnng several approaches. Ths structured model tres to examne the nnovaton process nsde the frm and address that t s not nnovaton nput such as R&D actvtes, rather nnovaton output that makes productvty ncrease. The CDM model bascally establshes three relatons represented by four equatons whch llustrate the fact that R&D actvtes produce knowledge captal whch ultmately contrbutes to productvty growth: 1) R&D actvty and ts determnants, 2) an nnovaton functon that relates R&D actvtes to nnovaton output such as patents or nnovatve sales, 3) a Cobb-Douglas type productvty equaton relatng nnovaton outputs to productvty. The frst relaton s represented by two research equatons: the R&D decson equaton and the R&D ntensty equaton. They descrbe the frm s decsons about whether to engage n and how much to nvest n R&D actvtes. One can assume that a frm would be engaged n R&D actvtes when the benefts from R&D actvtes exceed some ndustry specfc threshold whch s not observed by an econometrcan. Once the decson to perform R&D or not s made, 24

33 the frm decdes how much to nvest n those R&D actvtes. The second relaton s represented by nnovaton equatons whch are actually transformed from the Knowledge Producton Functon (Grlches, 1990). The nnovaton equatons are gven by the lnear relatons among observed nnovaton output such as a frm s sales from nnovatve products or servces and explanatory varables. The last relaton s represented by a productvty equaton augmented by the Cobb-Douglas producton functon wth output of nnovaton and other factors such as physcal captal, employment and skll composton, allowng arbtrary correlatons wth the errors of the above two equatons: the R&D ntensty equaton and the nnovaton equaton. Table 2.1 summarzes the major results across countres under the CDM model or ts varants that tred to estmate the relaton between frm-level nnovaton and ts performance 12. From a summary of the prevous emprcal results, one sees a broadly postve relatonshp between frm-level nnovatve actvtes and productvty regardless of whch measures are used as nnovaton output. For most European countres, the elastctes of nnovaton output for frm productvty le between 0.02 and 0.59, although some of them are not sgnfcant. The effects of nnovaton output when nnovatve sales are entered are much greater than those when 0/1 dummes of product and process nnovaton are used. Note that the effects of process nnovaton are more ambguous, sometmes negatve when used together wth a product nnovaton dummy. The measurement errors or ambguty of response due to havng a broader defnton n the dummy varables of process and organzatonal nnovatons may enhance the 12 For more results and detals, see Hall (2011) and Hall, Maresse and Mohnen (2010). 25

34 varablty. Instrument strategy may be an alternatve to mtgate the ambguty and help clearly dfferentate the effects (Hall, 2011). 26

35 Chapter 2 Tables and Fgures Table 2.1 Major fndngs of CDM models and ts varants across countres 13 Country Data used Tme perod Chle Chlean Innovaton Survey CDM Chna 5,451 Chnese manufacturng frms CDM wth IV French Innovaton survey by SESSI CDM Ireland Irsh CIS 2006 & CDM wth IV Netherland Fnland Germany Norway Sweden Italy Span CIS 2 & data from producton survey CIS 2 (323 frms) CIS 3 (575 R&D ntensve frms) CIS 2 (485 manufacturng frms) CIS 3 (474 R&D ntensve frms) Survey on Manufacturng (7,375 frms) CIS 3 (3,588 frms) CDM wth IV CDM wth IV CDM wth IV CDM wth IV CDM wth IV CDM varant ) * : sgnfcant at 10%, ** : sgnfcant at 5%, *** : sgnfcant at 1% Method Model Fnal output Innovaton output CDM wth sequental IV Value-added per employee Total sales per employee Value-added per employee Total sales per employee Total sales per employee Total sales per employee Total sales per employee Total sales per employee Total sales per employee Real sales per employee Total sales per employee Share of nnovatve sales Share of nnovatve sales Share of nnovatve sales Share of nnovatve sales Share of nnovatve sales Innovatve sales per employee Innovatve sales per employee Innovatve sales per employee Innovatve sales per employee Dummy of product and process Innovaton Dummy of product and process Innovaton Effect of nnovaton output 1) on productvty 0.179* 0.035*** 0.065*** 0.114*** 0.133*** *** 0.257*** 0.290*** 0.597***(product) (process) 0.176*** 13 These selectve results of varous CDM models across countres depend on the survey research by Hall (2011). 27

36 Fgure 2.1 Conceptual and operatonal framework of nnovaton process of SMEs Strategy and capablty of Innovaton [INPUT] Implementaton of Innovaton Responses to External Envronmental Change Internalzaton of Innovatve Responses Innovaton outcomes and Frm performance [OUTPUT] Innovaton Strategy - R&D expendture - Technology development Innovaton capablty - Number of adopted nnovatons - Innovaton related nformaton - Frm specfc nnovatve Responses to External Envronmental Changes - Factors hamperng nnovatons - Factors supportng nnovatons Implementaton of Innovatve Responses - Human resources - Physcal captals - Fnancng - Cooperaton and collaboraton Performance - Labor productvty - Value added per employee - Return on captals Outcomes - Sales from Innovatve products and servces - Number of patents - Dummes on product, process, organzatonal and marketng Independent Varables Intermedatng Varables Dependent Varables 28

37 CHAPTER 3 INNOVATIVE ACTIVITY AS A DETERMINANT OF PERFORMANCE HETEROGENEITY: EMPIRICAL EVIDENCE FROM KOREAN SMEs 3.1 Introducton What are the crucal channels that drve nnovaton at the frm-level, and to what extent can they account for aggregate dfferences n frm performance? There seem to be no other questons that have longer been explored than these to nvestgate the source of frm growth. Although several factors such as R&D, co-operaton, nformaton technology, tranng etc. were addressed as crucal to frm performance by econometrc efforts, R&D actvty, one type of frm-level nnovatve actvty, has long been consdered a crucal factor whch makes productvty heterogenety among manufacturng frms (Grlches, 1990). Maresse and Sassenou (1991), however, ponted out that t mght be dffcult to fnd an emprcally sold relatonshp between R&D and productvty. Ther fndng from the survey data s that the econometrc analyses concernng the relatonshp between R&D and economc performance lack robustness. They nstead conclude that a better understandng of the relaton nvolves attemptng to fnd more relable measures or ndcators for nnovatve actvtes such as human and knowledge captal, organzatonal change and external work and so on, whch ultmately determne a frm s performance. 29

38 As ponted out by Hall et al. (2009), the black box of the nnovaton process n SMEs ncludes a varety of unknown characterstcs from research and product development to market explotaton. Thus, an econometrc analyss on nnovaton and performance relatons, whch employs tradtonal measures of nnovatve actvty such as R&D expendture and patent counts, provdes only a lmted examnaton and nterpretaton, and does not reveal the full pcture of nnovatve actvtes wthn SMEs. Due to the mprovement of nnovaton survey data accumulated wthn OECD regons, how to measure the effects of nnovatve actvtes on productvty n SMEs has been a hot research topc for the past couple decades both because of polcymaker s concerns and n order to gan well-desgned econometrc applcatons. However, most of the emprcal studes that have tred to measure the effect of nnovatve actvtes (both for product nnovaton and process nnovaton) on frm performance stll do not seem to provde sold evdence to the magntude of those mpacts. Ths chapter, by sheddng lght on the underlyng relatonshp between frm-level nnovatve actvtes and frm performance (e.g. productvty) heterogenety, tres to develop an emprcal model and fnd evdence for underlyng connectons. The proposed model n ths chapter helps fnd new evdence for the mpacts of nnovatve actvtes on frm-level productvty dfferences usng data from the Korean Innovaton Survey (KIS) 2008 Manufacturng. Ths study also compares ts fndngs to emprcal results from other OECD countres, and derves some mplcatons for government polces whch are desgned to enhance nnovaton and R&D actvty of SMEs wthn OECD countres. 30

39 3.2 The econometrc model: Frm-level nnovatve actvty and productvty lnk Motvated by the emprcal CDM model and the results from several dfferent countres, ths study attempts to modfy the systematc equatons of the CDM model accordng to deas from Oslo Manual and to mprove the orgnal specfcatons so as to apply the data from the KIS 2008 Manufacturng. Followng the conceptual framework of the SME nnovaton process (Fgure 2.1), a schematc dagram of the nnovatve actvty and productvty lnk, as presented n Fgure 3.1, vsualzes the underlyng relatons hypotheszed n the model of ths study 14. Innovaton outputs, dvded nto four dfferent types of nnovaton, are subject to knowledge captal accumulated by contnuous R&D or non-r&d actvtes from the prevous perod. These outputs are hypotheszed to determne the frm-level productvty heterogenety along wth physcal captal stock and the qualty of labor employed. Furthermore, the formaton of knowledge captal, augmented by R&D and non-r&d actvtes, s partly ntated by frm-specfc and ndustry-specfc factors as well as market condtons. The systematc relatons are represented by the followng three equatons: the nnovaton nput equaton, the nnovaton output equaton and the productvty equaton. The man focus of these hypothetc relatons les on whether (or how) frm-level nnovatve actvtes contrbute to the dfference n frm-level 14 See Pakes and Grlches (1984), Crépon et al. (1998) for smlar concepts. 31

40 performance measures, controllng for fxed captal, employment, and other relevant factors affectng frm performance The nnovaton nput equatons Smlar to other typcal busness actvtes wthn a frm, frm-level nnovatve actvty as an nnovaton nput can be dvded nto two major decsons of a frm: 1) the frm s frst decson about whether to carry out nnovatve actvtes and 2) the ntensty or measurable amount nvested n those actvtes by the frm. Those decsons at the stage of nnovaton nput thus can be modeled wth two equatons: one descrbng a frm s decson about whether to be engaged n nnovatve actvtes to ncrease a proft n the future and another for the magntude of those actvtes gven that the frm decdes to carry them out. For most nnovatng frms, R&D s regarded as the most mportant and typcal actvty for future economc profts over any other actvtes. As ponted out by Hall et al. (2009), however, SMEs have varous knds of nnovatve actvtes whch are not captured by formal R&D measures, and nnovaton nputs thus do not have to be lmted to the formal R&D actvtes n SME cases. It can be assumed that there s a (latent) decson crteron for the frm about whether to be engaged n nnovatve actvtes that are not fully covered by the R&D nvestment measures. The decson process of nnovaton nput can then be represented by the followng lnear relaton wth bnary outputs (0, 1) and some explanatory varables as shown n Equatons (3-1) and (3-2): 32