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EBRD Transition Report 2014 – Firm-level drivers of innovation

TRANSITION REPORT 2014 Innovation in Transition

Firm-level drivers of innovation

Size and age of firms

A firm’s willingness and ability to innovate will depend on various characteristics. In particular, young, small firms are often perceived to be the main drivers of innovation. While such firms do make an important contribution to the development of new products, they are not necessarily more innovative than other firms when viewed as a whole.

This is partly because when young, innovative firms are successful, they often grow fast, thereby becoming larger firms. Google and Amazon were once start-ups with just a handful of employees, but they have quickly grown and now employ thousands of people. Innovative start-ups that are not successful, on the other hand, typically run out of funding and exit the market.1 Neither of these types of firm will be categorised as young, small firms in an enterprise survey such as BEEPS V or MENA ES. In addition, not all young, small firms are innovative start-ups. Many will be in conventional service sectors (takeaway restaurants or small convenience stores, for instance).

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For these reasons, innovation may be more common among larger firms that have been operating for a longer period of time. Chart 3.1, which uses BEEPS V and MENA ES data, shows that larger and older firms are indeed more likely to introduce new products. The same is true of new processes and marketing and organisational innovations. A similarly positive correlation between the size/age of a firm and its propensity to introduce new products or processes can also be observed in Israel and advanced economies more broadly.2

The positive correlation between firm size/age and innovation also holds in firm-level regressions. Table 3.1 presents estimates showing the impact of various firm-level characteristics that influence firms’ decisions to engage in R&D and introduce new products and processes. These results are based on the model discussed in Chapter 2 (see Box 2.1). Unlike the simple averages presented above, this model takes into account the industries and countries where firms operate, as well as various other firm-level characteristics (such as the type of firm ownership).

BEEPS V and MENA ES data suggest that economies of scale may also partly explain the positive correlation between firm age/size and innovation. The development of new products often involves high fixed costs and investment spikes. This may simply be easier for larger firms to bear – particularly if large firms enjoy better access to external finance, as discussed in Chapter 4. These large firms may also be more able to absorb new technologies.3 This may be one reason why small firms (defined as companies with fewer than 20 employees) are less likely to engage in R&D than larger firms (albeit they tend to spend a higher percentage of their annual turnover on in-house R&D; see Chart 3.2). Larger firms may also conduct more innovation projects, making them more likely to successfully introduce at least one new product in the course of a three-year period.

Perhaps unsurprisingly, differences between smaller and larger firms (and older and younger firms) in terms of innovation rates are more pronounced in high-tech manufacturing sectors such as machinery or pharmaceuticals, as complex technologies are more difficult and costly to absorb and develop.

Similar estimates of the impact of a firm’s size and age emerge from the regression analysis, which controls for other firm-level characteristics. Indeed, this analysis suggests that small firms are 5 percentage points less likely to introduce new or improved products or processes than large firms (see Table 3.1, column 2).4 This is a substantial impact, given that 27 per cent of large firms have introduced new or improved products or processes in the last three years.

What may be surprising is the fact that young and small firms are also less likely to introduce marketing and organisational innovations. This probably reflects the fact that larger firms tend to have employees specialising in marketing (or even whole marketing departments), whose main task is to review existing marketing techniques and develop new approaches to marketing.

TABLE 3.1

Determinants of R&D and innovation
  R&D
(1)
Technological innovation
(cleaned)
(2)
Non-technological
innovation
(3)

R&D

 

0.2160***

0.1973***

 

(0.0678)

(0.0328)

Firm age (years)

0.0003

0.0010**

0.0004***

(0.0002)

(0.0004)

(0.0001)

5-19 employees (dummy)

-0.0927***

-0.0549***

-0.0973***

(0.0088)

(0.0126)

(0.0127)

20-99 employees (dummy)

-0.0480***

-0.0315**

-0.0605***

(0.0070)

(0.0119)

(0.0121)

Majority foreign-owned (dummy)

0.0142

0.0235*

0.0428**

(0.0113)

(0.0130)

(0.0140)

Majority state-owned (dummy)

0.0041

-0.0320**

-0.0075

(0.0307)

(0.0115)

(0.0130)

Direct exporter (dummy)

0.0635***

0.0317**

0.0339**

(0.0090)

(0.0132)

(0.0138)

Percentage of working capital financed by banks or non-bank financial institutions

0.0004***

0.0002**

0.0006***

(0.0001)

(0.0001)

(0.0002)

Percentage of fixed asset purchases financed by banks or non-bank financial institutions

0.0004***

0.0010**

0.0007***

(0.0001)

(0.0004)

(0.0002)

Percentage of employees with a university degree

0.0007***

0.0001**

0.0004***

(0.0001)

(0.0000)

(0.0001)

Main market: local (indicator)

 

-0.0461***

-0.0423***

 

(0.0081)

(0.0085)

Use email for communication with clients (indicator)

 

0.0908***

0.1430***

 

(0.0103)

(0.0104)

Source: BEEPS V, MENA ES and authors’ calculations.
Note: This table reports average marginal effects. Standard errors are indicated in parentheses. ***, ** and * denote statistical significance at the 1, 5 and 10 per cent levels respectively. The regressions are estimated using an asymptotic least squares estimator based on the model described in Box 2.1.

CHART 3.1

Source: BEEPS V, MENA ES and authors’ calculations.
Note: Data for the transition region represent unweighted cross-country averages. Small firms have fewer than 20 employees; young firms are less than five years old.

CHART 3.2

Source: BEEPS V, MENA ES and authors’ calculations.
Note: Unweighted averages across transition countries. Small firms have fewer than 20 employees.

Scarcity of innovative start-ups

Young, small firms may tend to innovate less, but start-ups still represent a very important class of innovators. They are the firms that are most likely to come up with innovations that are new to the global market. In some cases, the innovation is the sole reason for the firm’s creation.

In Israel, two-thirds of small firms introduced product innovations that were new to the international market, compared with 48 per cent for larger firms (see Chart 3.3). Moreover, all young firms (defined as companies that were established less than five years ago) introduced at least one new product that was new to the international market, hence the fact that Israel’s start-ups have a reputation as one of the key drivers of economic growth in that country.

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In transition countries, by contrast, such start-ups remain rare. In fact, young and small firms in the transition region perform worse than their large and established counterparts when looking at the percentage of them that introduced product innovations new to the global market (see Chart 3.3). Younger firms are somewhat more likely than older firms to introduce world-class process innovations, but instances of such process innovation are very rare overall.

The scarcity of start-ups generating world-class innovation reflects the fact that transition economies are further removed from the technological frontier than advanced economies such as Israel. This may be due to a series of factors constraining the development of innovative start-ups. Among these factors are a lack of specialist financing (such as angel investors, seed financing and venture capital), skill shortages, high barriers to the entry of new firms and weak protection of intellectual property rights (all of which are discussed in more detail in Chapters 4 and 5), as well as the age of firms’ senior management.5

Faced with these constraints, the most successful innovative entrepreneurs and small firms in the transition region often move to Silicon Valley, Boston, New York and other innovation hubs at the earliest opportunity; some keep their development centres somewhere in eastern Europe (see Box 3.1 for a further discussion and examples). As transition economies develop and move closer to the technological frontier, young firms producing world-class innovation will become more prominent. The economic environment will need to adapt to this change and become more supportive of innovative start-ups (as discussed in more detail in Chapter 5, which looks at policies that can help start-ups to succeed).

CHART 3.3

Source: BEEPS V, MENA ES and authors’ calculations.
Note: Data for the transition region represent unweighted cross-country averages. This chart is based on cleaned innovation data. In Israel, all young firms introduced at least one new product that was new to the international market. Small firms have fewer than 20 employees; young firms are less than five years old.