Monday, July 23, 2012

Spreading the Word: Geography, Policy, and Knowledge Spillovers (Sharon Belenzon and Mark Schankerman)

Innovation and knowledge spillovers are key to economic growth, and universities play a central role. In the U.S., academic institutions spent $48 billion on R&D, accounting for 56 percent of basic research and 33 percent of total research in the U.S. (National Science Board, 2008). Academic research takes two main forms: scientific publications and, increasingly, patents. Promoting university innovation and its diffusion is a major policy objective. This policy focus assumes that knowledge spillovers are geographically localized. Thus it is important to understand how geography, and the characteristics and policies of universities and states, limit knowledge spillovers.

The importance of state borders: We focus on how state borders, and distance, influence the diffusion of knowledge from private and public American universities. While country borders typically signify zones with different cultures, languages, and political institutions, American states are unlikely to vary much on these dimensions. Moreover, separating state border effects from pure distance effects is difficult. Nonetheless, because state borders are not strongly associated with different linguistic, culture, or political institutions, they provide a clean framework for investigating how local policy influences knowledge spillovers.

We examine two ways that state borders can affect university knowledge diffusion: local information, and policies for commercializing university innovation. Local information is important when dealing with tacit knowledge, which can be explained as inventors located closer to the cited university having greater potential for learning than those located further away, which in turn encourages development of local information networks. The border effect should be stronger in states where inventors are more likely to remain in the state when they move jobs, and when inventors are more likely to have been educated at a local (in-state) university. State policies can also influence the prevalence of such local information. For example, “non-compete” labor laws make it more likely that inventors who shift employers will leave the state.

The second method involves policies that promote local commercial development of university innovations. This is more likely to occur in states with a dense and vibrant community of scientists and engineers. The state border is also likely to be more important for public universities, which are often constrained or influenced by state government. For example, public universities typically attach greater importance to promoting local and regional development through their technology licensing policies (Belenzon & Schankerman, 2009).

Our methods: We measure citations to university-owned patents. Citations have been widely used to trace spillovers from corporate R&D (Jaffe & Trajtenberg, 2002). However, citations to university patents are an imperfect measure, and many scientific contributions made by university faculty are never patented. We also examine the extent to which corporate patents cite university scientific publications.

A citation indicates that the later invention somehow builds on the earlier one, and that some knowledge transfer has occurred. Jaffe, Trajtenberg, and Henderson (1993), for example, compare the average distance of patents that cite another patent and a random control group of patents, in the same field, that do not cite. They show that firms located in the same city as the inventor are much more likely than others to benefit from knowledge spillovers from that innovation.

Geography can be summarized as identifying whether inventors are in same city, state, or country. Current studies, which do not measure geographic distance, are unable to explore in detail how distance affects citation rates. We address this gap by using the actual distance between the locations of patent assignees (measured by Google Maps), distinguishing between both the relationship between spillovers and geographic distance, and the impact of state borders. We show that citations decline sharply with distance up to about 150 miles, but are essentially constant beyond that. This strongly suggests that direct personal interaction plays an important role in knowledge flows. 

Findings: Controlling for distance, we find that inventors in the same state as the cited university are substantially more likely to cite one of the university's patents than an inventor outside the state. In contrast, we find that state borders have minimal, although varying, impact on citations by patents to university scientific publications.

The impact of state borders on patent citations differs widely across states. First, the border effect is larger in states that do not have, or do not strongly enforce, “non-compete” labor laws. These laws, which restrict employees from moving jobs to a competing firm within the same state for some period of time, should reduce knowledge spillovers and weaken the state border effect on citation behavior. Our findings reinforce studies that show that non-compete laws increase out-migration for job movers (Marx et al., 2007, 2010); we show that non-compete statutes also affect the knowledge diffusion that labor mobility generates.

Second, the border effect is stronger in states with a higher fraction of inventors educated in state, more scientists and engineers, and lower rates of interstate labor mobility for scientists and engineers.

Third, the border effect is much stronger for citations to patents from public universities. A substantial part of this effect is associated with local development focus. This finding has a potentially important policy implication. Belenzon and Schankerman (2009) show that universities with strong local focus earn substantially less licensing income from their inventions – but there may be offsetting benefits, such as greater localization of knowledge spillovers. This is key to understanding whether it makes economic sense for universities (or state governments) to promote local development through local licensing. We find a genuine trade-off, which policymakers should bear in mind.

Finally, we examine the differences in knowledge spillovers across technology areas. In fields where information is harder to transmit, direct social relationships are likely to play a larger role, making knowledge spillovers more sensitive to geographic distance. We find that localization occurs mostly in biotechnology, pharmaceuticals, and chemicals, and much less so in electronics, information technology, and telecommunications. This implies that some of the variation we observe in the strength of the border effect across states may be due to differences in technology specialization.

The Effect of Country Labor Regulation on Corporate Group Affiliation: Evidence from Europe (Sharon Belenzon and Ulya Tsolmon)


Works by Chandler (1962) and Penrose (1959) emphasize the importance of labor resources for firm performance and growth. Scholars have examined the economic effects of efficient allocation of labor (e.g., Nickell & Layard, 1999; Castanias & Helfat, 1991, 2001), but research on how labor management builds competitive advantage and shapes a firm is scarce. Our interest is in the conditions under which internal labor markets (ILMs) are likely to form. ILMs can shape firm boundaries, supporting the view of ILMs of large corporations as key to long-term success. We examine the importance of ILMs in the European Union through the combined effect of country labor regulations and industry conditions on firms’ strategic choice of organizing.

The institutional void theory (Leff, 1978) emphasizes the central role of firms in replacing missing or dysfunctional external markets. By organizing in corporate groups, firms benefit from a regulation-free internal labor market when adjusting their labor force. When markets inefficiently allocate labor across firms, the ILMs of large organizations can gain a more prominent role in such allocation activities (Spence, 1975; Leff, 1978; Khanna & Yafeh, 2007). We test the effect of ILMs on group affiliation and the relationship between industry-level labor turnover and country-level employment protection.

Why the EU? The European Union is an ideal environment for testing the ILM theory because its employment protection varies widely across countries. Employment protection regulations include legal rules, administrative procedures, and compensatory payouts that apply to employee dismissals. Unlike unemployment benefits, which are funded through taxes, employment protection regulations impose direct costs on the employer responsible for dismissals. For example, in Spain, dismissal procedures require 30-day written notice with a statement of reasons for dismissal and a written notification to the worker’s representatives at the workplace. Spanish employees are also entitled to severance pay equivalent to 33 days’ salary for each year of service. Similarly, Austrian workers with more than 3 years of service are entitled to 8 weeks’ notice and 6 months’ salary as severance pay (OECD Employment Outlook, 2004). Strict regulations effectively raise costs of terminating redundant or underperforming workers.

Corporate group exemptions: Under European Union law, however, worker movement within a corporate group is not considered a “market transaction.” This means that intra-group mobility is not subject to country labor-market regulations. The European Union Directive 96/71/EC grants group affiliates an exception that allows the transfer of employees among affiliates without having to dismiss and rehire each transfer – and therefore without being subject to employment protection regulations. Although it is important to note that there could be other costs contributing to labor adjustment costs, we focus on labor market regulations as highly costly in terms of lost productivity and limited growth. We would therefore expect more economic production within a country to be organized in corporate groups, where labor redeployment costs are muted.

Our paper also contributes to the large literature that studies the economic consequences of market regulation policy. Labor regulations have received special attention as a major source of costly market tension in the European Union (EU), where the popular press has recently argued that the sluggish growth is in fact the direct result of stringent employment regulation policy. We contribute to this debate by highlighting a critical strategic response of firms that can substantially reduce the productivity losses caused by extensive labor market regulations – namely, organizing labor market transactions within rather than between independent firms.

Empirical strategy: By comparing organization structures in 15 Western European countries, we examine how institutional differences affect whether firms form corporate groups. We examine the impact of high and low restriction of labor regulations on the difference in share of firms affiliated with a group between industries with high and low labor turnover. We focus on a set of economies which: i) share a clear and consistent definition of groups; ii) exist within a narrow range of economic development, such that we can separate developing and developed economies in our study; and iii) vary enough in the level of labor regulations and represented industries so that we may observe the impact of the interaction between industry labor turnover and country labor regulations.

We rank industries according to their level of labor turnover, using 1977–2003 data from the U.S. Bureau of Labor Statistics to calculate the average turnover rate for each industry. Then we rank the 15 countries in our sample according to the level of their employment regulations using the OECD Employment Protection Index and complementary measures. The index ranges from 0 to 6 (least strict to strictest) and takes into account indicators for regular employment, temporary employment, and collective dismissals. Though our focal countries are relatively wealthy and enjoy developed legal environments, they nonetheless exhibit measurably different levels of employment regulations. Greece (3.11), Spain (3.01), and France (2.88) are countries with the strictest employment protection regulations, while Great Britain (1.07), Ireland (1.25), and Switzerland (1.60) have the fewest restrictions on employee dismissals.

Findings: Our findings strongly support the internal labor markets hypothesis. Industries with high labor turnover have disproportionately more group-affiliated firms than low-turnover industries, especially in countries with high employment regulations. Importantly, we find that the relevant measure of country regulation is the extent to which firms face job termination restrictions, whereas we find no effect for country unemployment protection. This is consistent with the view that firms organize as corporate groups partly as a response to increased country regulations on labor mobility. Consistent with the ILM theory, we find stronger effects when comparing standalone firms to firms that are affiliated with larger and more diverse groups. We also note that, where labor regulation and employment turnover are quite high, both large size and active internal labor markets may be a source of long-term competitive advantage.

Married to the Firm? Family Ownership, Performance, and Financing in Private Firms (Sharon Belenzon and Rebecca Zarutskie)


Family-owned firms are common worldwide and comprise a significant share of assets and economic activity. However, there is debate about how family ownership influences firm behavior and performance. Stewardship theory (Davis et al., 1997; Stark & Falk, 1998) suggests that family-owned firms may do better when families are concerned about preserving the reputation and performance of the firm and the family name. However, agency theory suggests that family-owned firms are likely to underperform since family owners may focus on the family, or certain family members, over the economic value of the firm (Jensen & Meckling, 1976; Schulze et al., 2001).
Much of the existing evidence on the relative performance and behavior of family-owned and non-family-owned firms relies on samples of larger, established, often public firms (for example, Anderson & Reeb, 2004; Bertrand & Schoar, 2006; Le Breton-Miller et al., 2011) or focuses on succession (for example, Perez-Gonzalez, 2006; Bennedsen et al., 2007; Ellul et al., 2010). There is less evidence of how family ownership influences private firms. The scarcity of evidence represents a gap in our understanding, since scholars, practitioners, and policymakers would like to understand how the initial ownership and organization of young firms is related to their future performance.
This study, which uses detailed data on the owners and financials of private firms across Europe, documents the selection of firm types and ownership structures. By observing young firms, we identify ways that business opportunities may be differently selected by family and non-family owners. We also distinguish between firms owned by a married couple and those owned by other types of family members, such as parents and children or siblings. We find that family owners tend to choose opportunities with higher returns and more stability, yet more limited growth potential. Family-owned firms also have more limited investment opportunities, especially with married shareholders. We discuss several things that may drive these patterns.

What is a family-owned firm? We define family-owned firms as those having at least two shareholders that are family members. Thus, our focus is on family ties between owners, rather than family ties between employees and owners or between current and future owners. Family-owned firms represent 20% of firms in our sample of 210,464 firms, and 30% of the 130,802 firms with at least two shareholders. Family-owned firms are prevalent across all industries, comprising up to 50% of firms in such industry segments as automotive repair and agriculture, and as little as 10% in industry segments such as accounting and advertising. We find a substantial share of family-owned firms in both high- and low-tech industries. For instance, close to 30% of the firms in chemicals are family-owned, which is very similar to the share of family-owned firms in building construction (28%).
Family ownership is associated with more stable, but slower growing, young firms. Family-owned firms on average have returns on assets that are 1.6 percentage points higher, profit margins that are 1.1 percentage points higher, and survival rates that are 2.5 percentage points higher than non-family-owned firms. These differences are even stronger for firms in which the two leading shareholders are married. The higher returns, profit margins, and survival rates in family-owned firms are associated with greater cash reserves. Family-owned firms also rely less on outside debt relative to non-family-owned firms, and have lower operating costs, such as employee wages, relative to non-family-owned firms. Lower wages explain close to 30% of the liquidity reserves of family-owned firms, and a third of the profitability dispersion.
These patterns hold with the view that family-owned firms manage their cash conservatively, spending less on wages and other operating costs and retaining more of their earnings in the firm. The greater cash reserves of family-owned firms may help them to better weather shocks and signal stability to suppliers, customers, and employees, which may keep profit margins high and increase their survival rates. However, these spending policies are also associated with lower rates of investment and growth. Sales growth rates of family-owned firms are on average 1.7 percentage points lower than for non-family firms, and 11 percentage points lower for firms under the age of 10 (the sample median).

Why? Several things may explain these patterns, including different management practices between private family and non-family-owned firms. The stewardship view suggests that family-owned firms focus on the reputation and stability of the firm, sacrificing current growth for a higher chance of survival. However, our results are also consistent with the agency view that some value may be sacrificed in order to maintain stability. This is not the same as the use of the firm's resources to benefit current family members at the expense of the firm's current stability and value (for example, Schulze et al., 2002), since cash stays within the firm rather than going to current higher wages or dividends. However, our findings suggest this cash could be more profitably deployed by investing in the firm.
Our results do not suggest that family-owned firms perform better or are more likely to survive because there are fewer conflicts of interest or better monitoring between owners and managers. We do find that they exhibit higher returns, profits, and survival relative to single-shareholder firms in which the owner and manager are the same person. We also find that family-owned firms exhibit lower investment and growth. Overall, our analysis highlights distinct trade-offs to family ownership in private, especially young, firms in which stability is valued over investment and growth.

What does this mean? Without drawing broad policy implications from our analysis, our findings suggest that family ownership is neither a dominant nor dominated ownership form in young, private firms in terms of the outcome measures we consider – returns, profit margins, survival, and growth. Rather, our findings suggest trade-offs to family ownership in young firms as measured by these outcomes. Thus, environments or policies that encourage family ownership of private firms would also likely embody the trade-off of greater stability and slower growth of firms.

Thursday, February 2, 2012

CUMULATIVE INNOVATION AND MARKET VALUE: EVIDENCE FROM PATENT CITATIONS, by Sharon Belenzon



Knowledge spillovers play a critical role in economic growth. The basic argument is that change is often achieved by recombining existing ideas in novel and unexpected ways. However, because knowledge frequently lies outside the boundaries of the inventing firm, it is important to understand how outside knowledge feeds and interacts with internal R&D. I propose a new construct of knowledge recombination in the context of sequential innovation, conceptualizing new combinations of knowledge as the ability of a firm to combine its past inventions with follow-up external developments. Differences in the ability of firms to creatively reuse their own knowledge with external ideas explain a large part of the cross-firm differences in the value of intangible assets.

Using patent and citation data, I propose a new way of measuring the re-absorption of “spilled” knowledge by inventing firms. I distinguish between two types of citations from outside inventors: internal and external. Internal citations are made by patents connected to the firm. An example would be Microsoft citing a 2010 Intel patent that cites a 2008 Microsoft patent. In this example, Intel's follow-up development of the original Microsoft patent is internalized by Microsoft in its later invention. External citations, by contrast, are those that do not feed back into the original inventor's research program in any subsequent period.

On the one hand, spillovers encourage innovation by providing the basis for future research. On the other hand, firms don’t want to spawn research that may ultimately undermine their market position or render their own research obsolete. The prospect of future research undermines the process of knowledge creation in the first place. This effect can be so large as to create a “no-growth” trap where the incentives of early inventors to invest in R&D completely disappear. However, little work has been done to examine whether this negative effect of spillovers may be mitigated. If the inventing firm could reabsorb its spilled knowledge in a future period together with subsequent developments made by other inventors, it might be able to escape the no-growth trap and sustain its long-term returns.

Previous research mostly focused on how private profits from innovation can be shared contractually between early inventors and their followers. The consensus is that explicit agreements between the first and second innovator can be beneficial, because they compensate the early innovator for their losses due to shorter patent life. However, designing and enforcing contracts that would allow enough transfer of profits and eliminate the question of incentives is arguably a very difficult task. Coordination costs, overlapping patent claims (“thickets”) and hold-up problems are some of those issues. This difficulty emphasizes the need to deepen our understanding of how private rents can be captured by rent-seeking enterprises, especially when inventions are highly dependent on one another. By combining past firm-specific knowledge with outside follow-up developments, the firm can potentially not only mitigate loss of profits by offering new products, but also to capitalize on R&D complementarities between its past research efforts and relevant outside developments.

An example that illustrates the relationship between spillovers and private rents to innovation is the Computed Tomography (CT) scanner invention. The CT technology was invented and patented by EMI. While being extremely successful and profitable for EMI, it also inspired hundreds of subsequent inventions by firms such as Pfiser, Syntex, Picker, and General Electric. A few years later these firms dominated the CT scanner market, forcing EMI to drop out.

The spillovers generated by the original EMI invention were mostly external to EMI, meaning that those spillovers were not useful to EMI. While EMI was responsible for the creation of one of the most influential medical inventions of the 20th century, it lacked the capability needed follow up its invention with outside discoveries and remain at the technology frontier. This brings us to our central question: do firms whose inventions result primarily in external knowledge spillovers have a lower stock market value than firms whose inventions result in more internal knowledge spillover?

In economics, the number of times a patent is cited provides useful information about patent’s importance. Citations are also used to measure knowledge spillovers. Both patent quality and knowledge spillover aspects of citations can help determine the inventing firm’s profits, as well as shed light on the relationship between innovation and firm value.

I use information on patent citations to learn about subsequent development of knowledge. Patent citations are a legal instrument used to determine the scope of patent protection. The inventor identifies prior projects that are technically related to the patent application. If patent B cites patent A, that indicates that patent A contains a piece of knowledge on which patent B builds. (Clearly, this piece of knowledge is excluded from the scope of patent B.) I use citations to construct sequences of patents that cite each other. I analyze each sequence to classify patents along the sequence as internal, external, or self-citations.

Using data on about 1,200 American patenting firms between 1981 and 1997, I find a strong, positive relationship between measures of knowledge recombination and stock market value. Specifically, I find a positive relationship between market value and internal citations, and a negative relationship between market value and external citations. Increasing the share of internal citations by the sample average and assuming that the change comes from having fewer external citations is associated with an increase in $70 million in market value. Moving from the 10th to the 90th percentile in share of internal citations is associated with an increase of about 10% of firms' average value.

As one would expect, I find a stronger relationship between value and citations in more cumulative, rather than discrete, technology areas (for example, telecommunications versus drugs). Internalization is less likely to be effective in industries where inventions are more dependent on one another. In such industries reapplying knowledge has a stronger effect on value.