Chapter 3 DRIVERS Of INNOVATION

Chapter 3DRIVERS OF INNOVATIONsuch as machinery or pharmaceuticals, as complex technologiesare more difficult and costly to absorb and develop.Similar estimates of the impact of a firm’s size and age emergefrom the regression analysis, which controls for other firm-levelcharacteristics. Indeed, this analysis suggests that small firmsare 5 percentage points less likely to introduce new or improvedproducts or processes than large firms (see Table 3.1, column 2).4This is a substantial impact, given that 27 per cent of large firmshave introduced new or improved products or processes in thelast three years.What may be surprising is the fact that young and small firmsare also less likely to introduce marketing and organisationalinnovations. This probably reflects the fact that larger firms tendto have employees specialising in marketing (or even wholemarketing departments), whose main task is to review existingmarketing techniques and develop new approaches to marketing.Scarcity of innovative start-upsYoung, small firms may tend to innovate less, but start-ups stillrepresent a very important class of innovators. They are the firmsthat are most likely to come up with innovations that are newto the global market. In some cases, the innovation is the solereason for the firm’s creation.In Israel, two-thirds of small firms introduced productinnovations that were new to the international market, comparedwith 48 per cent for larger firms (see Chart 3.3). Moreover, allyoung firms (defined as companies that were established lessthan five years ago) introduced at least one new product thatwas new to the international market, hence the fact that Israel’sstart-ups have a reputation as one of the key drivers of economicgrowth in that country.In transition countries, by contrast, such start-ups remain rare.In fact, young and small firms in the transition region performworse than their large and established counterparts when lookingat the percentage of them that introduced product innovationsnew to the global market (see Chart 3.3). Younger firms aresomewhat more likely than older firms to introduce world-classprocess innovations, but instances of such process innovationare very rare overall.The scarcity of start-ups generating world-class innovationreflects the fact that transition economies are further removedfrom the technological frontier than advanced economies suchas Israel. This may be due to a series of factors constrainingthe development of innovative start-ups. Among these factorsare a lack of specialist financing (such as angel investors, seedfinancing and venture capital), skill shortages, high barriers to theentry of new firms and weak protection of intellectual propertyrights (all of which are discussed in more detail in Chapters 4 and5), as well as the age of firms’ senior management.5Faced with these constraints, the most successful innovativeentrepreneurs and small firms in the transition region oftenmove to Silicon Valley, Boston, New York and other innovationhubs at the earliest opportunity; some keep their developmentcentres somewhere in eastern Europe (see Box 3.1 for a furtherdiscussion and examples).45 riffith et al. (2006) find that large firms are more likely to engage in R&D in four advanced EuropeanGcountries. Acemoğlu et al. (2014) show that younger managers are more open to new ideas, so they are more likely toinstigate disruptive, risky innovations.47CHART 3.2. Percentage of firms engaged in R&D and their level of R&D spending,broken down by firm size14Percentage of firms engagedin in-house R&DR&D spending as a percentageof annual sales0.35120.3100.2580.260.1540.120.050Small firmsMedium/large firmsSmall firmsMedium/large firms0Source: BEEPS V, MENA ES and authors’ calculations.Note: Unweighted averages across transition countries. Small firms have fewer than 20 employees.CHART 3.3. Percentage of firms with product innovations that are new to theglobal marketFirm size10070Firm age6050403020100SmallMedium/largeYoungTransition regionOldIsraelSource: BEEPS V, MENA ES and authors’ calculations.Note: Data for the transition region represent unweighted cross-country averages. This chart is based oncleaned innovation data. In Israel, all young firms introduced at least one new product that was new to theinternational market. Small firms have fewer than 20 employees; young firms are less than five years old.27%of large firms in thetransition region haveintroduced new orimproved products orprocesses in the lastthree years

Chapter 3EBRD TRANSITION REPORT 201448As transition economies develop and move closer tothe technological frontier, young firms producing world-classinnovation will become more prominent. The economicenvironment will need to adapt to this change and becomemore supportive of innovative start-ups (as discussed inmore detail in Chapter 5, which looks at policies that canhelp start-ups to succeed).Type of ownershipAnother important characteristic affecting innovation is thetype of firm ownership. In general, foreign ownership and theintegration of local firms into global supply chains are expectedto lead to increased innovation (see Box 3.2). On the other hand,concerns are sometimes raised that multinational companiesmay conduct all of their R&D activities in their home countries,outsourcing only lower-value-added activities to emergingmarkets, so foreign takeovers may actually result in reducedspending on R&D.6Evidence from BEEPS V and MENA ES suggests that the firstof these effects tends to dominate in the transition region andthat foreign ownership is associated with an increased likelihoodof innovation and higher levels of spending on in-house R&D.Foreign-owned firms are defined here as firms where foreignCHART 3.4. Percentages of foreign-owned and domestic firms that are engagedin innovation302520151050Product innovationProcess innovationForeign-owned firmsOrganisational innovationMarketing innovationDomestic firmsSource: BEEPS V, MENA ES and authors’ calculations.Note: Unweighted averages across transition countries. Cleaned data for product and process innovations;unadjusted data for organisational and marketing innovations. “Foreign-owned firms” are those where theforeign stake totals 25 per cent or more. “Domestic firms” include locally owned firms and firms with foreignownership totalling less than 25 per cent.6 See, for example, Sample (2014).investors hold a stake of 25 per cent or more – that is to say,at least a blocking minority. The percentage of such firmsthat have introduced new products is significantly higher thanthe percentage of locally owned firms that have done so. Thesame is true of process innovations, as well as marketing andorganisational innovations (see Chart 3.4).Indeed, in the case of marketing and organisationalinnovation, the impact of foreign ownership is pronounced evenwhen foreign investors own a small stake that falls short of ablocking minority (in other words, between 0 and 25 per cent),while foreign ownership does not have a clear impact on productand process innovations until that stake reaches the 25 per centmark. This suggests that foreign owners may be an importantsource of information about new organisational arrangementsand marketing methods. At the same time, sharing technologicalknow-how requires stronger incentives and assurances, whichcome with a stake of a certain size in a company.The results also suggest that increased innovation byforeign-owned firms is a result of a mixture of “make” and “buy”strategies when it comes to acquiring external knowledge.The percentage of foreign-owned firms that invest in R&D(thereby pursuing a “make” strategy) tends to be higher than thepercentage of domestic firms that follow this strategy (see Chart3.5). This is the case in virtually every country in the transitionregion. Foreign-owned firms also tend to spend more on R&D(see Case study 3.1 for details of a joint venture in the Turkishautomotive sector with an active domestic R&D programme).Overall, these findings run counter to the view that foreigntakeovers undermine domestic R&D.Not only do foreign firms “make” more knowledge, theyare also more likely to engage in the acquisition of externalknowledge (through the purchasing or licensing of patents andnon-patented inventions and know-how) than locally owned firms(see Chart 3.5).The formal regression results in Table 3.1 confirm that therelationship between foreign ownership and innovation holdswhen other firm-level characteristics are also taken into account.Everything else being equal, a majority foreign-owned firm is,on average, 2.3 percentage points more likely to introduce newproducts or processes (see column 2) and 4.3 percentage pointsmore likely to introduce organisational or marketing innovations(see column 3).7 This is a sizeable difference, given that theaverage probability of a majority domestic-owned firm introducingnew or improved products or processes is 17.5 per cent, whilethe probability of it introducing organisational or marketinginnovations is almost 27 per cent.In contrast, majority state-owned firms are significantly lesslikely to introduce new products or processes than locally ownedprivate firms or foreign firms, and this effect is even larger in thecase of new processes. This may reflect the fact that managersof state-owned firms have weaker incentives to achieve efficiencysavings and improve productivity. Their remuneration, forexample, is not necessarily linked to their firm’s performance, andthese firms can typically rely on the state to bail them out in theevent of poor performance.7 respi and Zuñiga (2012) find mixed results for South America, with foreign ownership having a significantCpositive impact on R&D in Argentina, Panama and Uruguay, but not in Chile, Colombia or Costa Rica.

Chapter 3DRIVERS OF INNOVATIONCHART 3.5. Foreign-owned firms spend more on obtaining knowledge200.4150.3100.250.10Foreign-owned firms0Domestic firmsPercentage of firms investing in in-house R&D (left-hand axis)Percentage of firms engaged in acquisition of external knowledge (left-hand axis)Spending on in-house R&D as a percentage of annual turnover (right-hand axis)Source: BEEPS V, MENA ES and authors’ calculations.Note: Unweighted averages across transition countries. The acquisition of external knowledge includes theoutsourcing of R&D and the purchasing or licensing of patents and non-patented inventions or know-how.“Foreign-owned firms” are those where the foreign stake totals 25 per cent or more. “Domestic firms”include locally owned firms and firms with foreign ownership totalling less than 25 per cent.

DRIVERS Of INNOVATION R&D incReases the likelihooD of intRoDucing new p26RoDucts oR pRocesses by % foR high-tech compa manufactuRing fiRms f9iRms that use ict aRe % moRe likely to intRoDuce new pRoDucts oR pRocesses 29 % of expoRteRs have intRoDuceD a new pRoDuct oR pRocess, ReD with 15% of non-expo Rte s At A gl nce. Chapter 3 DRIVERS Of INNOVATION 45 Firms that innovate are more sensitive to .