Economics of Innovation and New Technology

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The nonlinear effects of firm size on innovation: an

empirical investigation

Xin Fang, Noelia R. Paez & Bei Zeng

To cite this article: Xin Fang, Noelia R. Paez & Bei Zeng (2019): The nonlinear effects of firm
size on innovation: an empirical investigation, Economics of Innovation and New Technology, DOI:
10.1080/10438599.2019.1677013

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ECONOMICS OF INNOVATION AND NEW TECHNOLOGY
https://doi.org/10.1080/10438599.2019.1677013

The nonlinear effects of firm size on innovation: an empirical

investigation
Xin Fang , Noelia R. Paez and Bei Zeng
College of Business, Hawaii Pacific University, Honolulu, HI, USA

ABSTRACT ARTICLE HISTORY

In conventional studies, large firms tend to emphasize more on process Received 19 December 2016
innovation than product innovation. This paper explores factors that Accepted 26 September 2019
could indicate a distinct pattern of firms’ innovation-size relationship:
KEYWORDS
threshold size that implies a positive effect of firm size on the Firm size; innovation;
probability of product innovation success; cannibalization effect that cannibalization; threshold
creates incentives for large firms to favor product innovations; and size; nonlinearity
financial constraints that have differential effects given different firm
sizes. A hypothesis about a non-monotonic relationship between the JEL
proportion of product innovation and firm size is tested with nonlinear L2; L6
and dynamic econometric models. For the large firms, empirical
evidence shows product innovations result in an overall larger share of
new products in total sales, relative to existing products in which
process innovations are rooted.

1. Introduction
Innovation is crucial for total factor productivity, industry and economic growth. The importance of
Research and Development (R&D) is underscored by the fact that companies invest about the same in
economic downturns as they do in more prosperous times.1 Firm size, however, is an important indi-
cator of market power and therefore becomes relevant for antitrust policies as large firms are often
accused of manipulating prices and reducing social efficiencies. In the innovation literature, firm size
is a key driver for R&D decisions. As Scherer (1980) states, ‘size is conducive to vigorous conduct of
R&D.’ Size consistently influences the probability of investing in R&D (Sasidharan and Kathuria 2011).
Large firms could have a higher probability of pursuing R&D, although with lower intensity (Ghosh
2009), and if proven more actively engaged in innovative investments would take a more favorable
stand in bringing benefits to economic efficiencies and consumer welfare.
Size-innovation relationships have been widely probed but remain controversial. Schumpter
(1950) initially implies that large firms tend to be more innovative, especially in formal R&D activities,
due to their human resources, economies of scale, market power, financing and appropriation capa-
bilities. This conclusion has been supported by many recent studies (Lerner, Shane, and Tsai 2003;
Bhattacharya and Bloch 2004; Shefer and Frenkel 2005; Tsai and Wang 2005; Svetličič, Jaklič, and
Burger 2007; Aragón-Correa et al. 2008; Ghosh 2009; Sasidharan and Kathuria 2011; Baumann and
Kritikos 2016). However, some studies show small firms prevail in rapid innovation with quick
responses to industrial change because of their flexibility, better communication, higher motivation,
and managerial advantages (Chakrabarti and Halperin 1991; Schwalbach and Zimmerman 1991;
Poyago-Theotoky 1996; Chen and Hambrick 1995; Dean, Brown, and Bamford 1998; Stock, Greis,

CONTACT Xin Fang xfang@hpu.edu College of Business, Hawaii Pacific University, 900 Fort Street Mall, Pioneer Plaza Suite
600, Honolulu, HI 96813, USA
© 2019 Informa UK Limited, trading as Taylor & Francis Group
2 X. FANG ET AL.

and Fischer 2002; Plehn-Dujowich 2009). Other research suggests that the relationship between size
and innovation is inconclusive or non-monotonic (Graves and Langowitz 1993; Lee and Sung 2005;
Majumdar 2011; Forés and Camisón 2016). Khachoo and Sharma (2017) affirm a non-linear and posi-
tive impact of firm size on R&D which also matches with some of the previous empirical findings such
as that of Kumar and Aggarwal (2005) and Pradhan (2003).
R&D investments are heterogeneous. An innovative firm may allocate R&D between process inno-
vations that ‘reduce the cost of producing existing products’, and product innovations that ‘create
new or significantly improved products’.2 The resource allocation decision is ultimately related to
firm size. Several earlier papers examine this relationship theoretically and empirically. It is usually
agreed that large firms tend to emphasize more on process innovation than product innovation
(Scherer 1991; Cohen and Klepper 1996b; Yin and Zuscovitch 1998; Fritsch and Meschede 2001;
Vaona and Pianta 2008). Some evidence of a non-monotonic relationship between firm size and
the allocation of innovation funds has also been discovered, e.g. Pavitt, Robson, and Townsend
(1987) find that the smallest innovating firms are the least process-oriented, followed by the
largest firms and, interestingly, mid-sized firms are most process-oriented. Choi and Lee (2018)
also found empirical evidence of a non-linear relationship between firm size and the product R&D.
This paper sheds light on the importance of factors that are missing in past studies of innovation
choice and firm size: threshold size and cannibalization effects. In fact, when they are considered, it is
possible to observe distinct changes to the usually predicted monotonic relationships. The scale
advantage of large firms in process innovation would be weakened by cannibalization, while
strengthened in product innovation because of threshold size. Therefore, the relationship between
share of product innovation and firm size is predicted to be potentially non-linear.
We use firm-level data from the Mannheim Innovation Panel Manufacturing and Mining & Services
survey (MIP) from 1993 to 2016 to study the relationship between the proportion of product inno-
vation and firm size by introducing threshold size, cannibalization effects, spillover effects, and
financial conditions into the modeling. Moreover, we include the process innovation dummy and
dynamic terms to empirically investigate potential complementarities and spillovers of previous
and current innovations. Two nonlinear approaches are specifically chosen to accommodate the
hypothesized pattern of innovation-size relationships.
Our empirical evidence shows that product innovations outweigh process innovations for a large
profit-seeking firm in most industries. Specifically, the probability of product innovation increases
with firm size when firms are small. Once the threshold size is crossed, the share of new products
in total sales tends to fall very slightly with a further firm size increase. We find relatively weak evi-
dence of non-monotonicity. Firm size increases are on average associated with a larger proportion
of new products, which implies that larger firms excel in product innovation, in both absolute and
relative terms.
This paper is organized as follows. The following section reviews the literature and outlines the
framework of the model used. Threshold size and cannibalization arguments are also discussed in
detail. An extended theoretical model is included in Appendix A. With a prediction for the existence
of nonlinearity and non-monotonicity, Section 3 specifies the empirical approach, tests the hypoth-
esis with the Hurdle Model and Quasi Maximum Likelihood Estimation (QMLE), and incorporates the
possible spillovers from previous innovations. Finally, concluding remarks are presented and impli-
cations discussed.

2. Literature and theoretical framework

The relationship between process and product innovations has been extensively discussed in the lit-
erature (Abernathy and Utterback 1982; Barnett and Clark 1996; Fritsch and Meschede 2001; Miravete
and Pernias 2006; Plehn-Dujowich 2009; Dhanora, Sharma, and Khachoo 2017). For a multiple-
product firm, both innovations would be conducted to take advantage of scope economies and
exploit the complementary features to enhance the productivity of R&D investment. Implementation
 ECONOMICS OF INNOVATION AND NEW TECHNOLOGY 3

of a product innovation could make corresponding process innovation necessary, while process inno-
vation may increase the returns or possibility of success of the product R&D investment by improving
the quality and enhancing the features of new products (Fritsch and Meschede 2001; Miravete and
Pernias 2006; Lin and Saggi 2002; Milgrom and Roberts 1995). Some empirical evidence has been
found to support a positive correlation (Damanpour and Gopalakrishnan 2001; Miravete and
Pernias 2006; Ballot et al. 2015; Baumann and Kritikos 2016). In the works of others, two types of inno-
vation take place in different stages of technological life cycle (Adner and Levinthal 2001) and the two
types of innovations are more detached at early stages of product development and more inter-
related at later stages of life cycle for a product (Utterback and Abernathy 1975). Alternatively,
some papers argue that the two forms of innovation are ‘the results of separate innovative processes,
pursuing different objectives with different means’ (Utterback and Abernathy 1975; Ettlie, Bridges,
and O’keefe 1984; Pianta 2001; Vaona and Pianta 2008).
A typical linear model usually considers product and process innovation as independent pro-
cedures in product development (cf. Cohen and Klepper 1996a; Lambertini and Orsini 2000). The
empirical results of Cohen and Klepper (1996a) show some indirect evidence that large firms
invest relatively more in process innovation. The results seem intuitive and are supported by a
majority of the literature, including those modeling simultaneous choices of the two innovations
(Scherer 1991; Fritsch and Meschede 2001; Rosenkranz 2003; Vaona and Pianta 2008). Moreover, Sti-
glitz and Weiss (1981) suggest that firms with financial constraints might take on risky projects to
meet the high cost of capital. The equity-holders of small firms (i.e. owner-managers of small
business) can gain more from successful innovation than debt-holders due to their asymmetric
payoff structure, which makes the moral hazard problem created by information asymmetries
worse. This consequently motivates small firms to develop new products with higher risk-taking
than improving processes. However, Fritsch and Meschede (2001) found no statistically significant
difference in optimal R&D choice accounting for possible interrelationships between process and
product R&D investments. Choi and Lee (2018) suggest a positive relationship between firms’
output and share of product R&D and found some empirical evidence with a non-linear model.
In this study, we try to further explore the size effect on process and product innovation choice by
incorporating the threshold size and cannibalization effect as well as some implications of excess
cash flow in the finance literature. Nelson, Peck, and Kalachek (1967) suggests the existence of a
threshold size that must be obtained for a firm to successfully engage in innovation because inno-
vation is characterized by significant economies of scale and scope. In an earlier study of Arrow
(1962), it is mentioned that smaller firms might underinvest in R&D because of risk aversion,
financial weaknesses and inability to appropriate the returns to R&D fully. Large-scale projects are
more likely to be carried out by large firms due to the huge fixed and sunk costs and risks involved.
If firms are not large enough, their innovation efforts are nonexistent. In the study of Australian man-
ufacturing businesses, Bhattacharya and Bloch (2004) found that a threshold size of firms exists for
any industry, and formal R&D is hardly conducted if firm size falls under that. Fritsch and Meschede
(2001) argue that ‘indivisibilities of innovation activities imply a certain amount of fixed costs of R&D
projects that work as a threshold for the decision to engage in R&D activity at all.’
A threshold size for innovation exists also because there are borrowing constraints related to inno-
vations. Financing problems can prevent a small firm from conducting innovation alone; and
cooperation with other firms could be problematic as well due to the allocation of ownership and
control, especially when the capital requirement is substantial relative to the intellectual inputs (cf.
Ettlie and Rubenstein 1987; Aghion and Tirole 1994; Lerner, Shane, and Tsai 2003). All mentioned
above translates into innovation being considered as a very expensive process with high uncertainty,
long investment horizon, and severe information asymmetry and intangibility. Also, R&D projects
have little or no collateral value (Kumar and Langberg 2009). It is well established in the literature
that firm size is negatively correlated with financial constraints, and financing innovative projects
is more challenging for small firms than large ones (Bergemann and Hege 2005; Brown, Fazzari,
and Petersen 2012; Hsu, Tian, and Xu 2014). Consistent with the findings on financing for small
4 X. FANG ET AL.

businesses, Westhead and Storey (1997) and Hogan and Hutson (2005) both find that small enter-
prises subject to financing constraints because of information asymmetries prefer internal
financing to outside equity or debt funds.
In the existing literature, threshold sizes were mainly discussed in the context of total R&D activi-
ties and success, while threshold sizes for process innovation and product innovation are unlikely to
be the same. Process innovation is generally subject to a lower size threshold, probably because the
revenue of established products already exceeds or equals production costs for an operational firm.
With the success of process innovation, costs will fall and positive profit margins will be enlarged.
However, revenue from new products needs to cover not only the innovation cost, but also the pro-
duction cost, thus requiring on the margin higher returns to product innovation. Similar to the mono-
polistic model (Carlton and Perloff 2004), innovation cost as part of fixed cost in production tends to
lower the possibility of introducing new products, but unlikely to interrupt current production on
which process innovation is based on. Process innovation often occurs on an incremental basis
while innovation that completely replaces current technology often relates to new products (Yin
and Zuscovitch 1998). As a result, product innovation projects are usually more radical, riskier and
costlier. A firm’s choice of radical versus incremental innovations is also reflected in a product life
cycle. Due to its continual evolution nature, radical innovations are mainly adopted during the
early production development phase, with emphasis on product performance and variety aiming
at more radical market innovations (cf. Kamien and Schwartz 1978). On the other hand, typical
process innovations, such as the improvements in the way an existing product is produced, are
usually the emphasis of incremental innovations at the advanced stages of the product life cycle.
Therefore, it is reasonable to assume that the threshold size for product innovations would be
higher. This hypothesis is consistent with real-world observations. For example, the invention of a
new drug or HDTV both cost hundreds of millions of dollars. Accordingly, the financial constraints
on product innovation would be more pronounced (Czarnitzki and Hottenrott 2011).
Facing a higher threshold size, a corner solution is more likely to arise for product innovation. Firm
size has long been argued to affect a firm’s profitability. Absolute gains from a given percentage
improvement in product characteristics are larger for large firms, or can be realized faster (Nelson,
Peck, and Kalachek 1967; Fritsch and Meschede 2001). Under imperfect capital markets, large firms
have more internal funds and superior access to external funds, so that firm size increases would
raise the probability of successful innovation. Marketing, sales, and distribution can all be better con-
ducted within large firms; and large firms can also diversify and spread out the risks of R&D, making it
possible to invest in risky projects with higher returns (Holmstrom 1989). There are also studies
showing that large firms with excess free cash flows and low investment opportunities are more
likely to invest excess funds in projects that are either unproductive or too risky due to agency pro-
blems (Jensen 1986, 2001; Bernanke and Gertler 1989; Stulz 1990; La Porta et al. 1999; Chen et al.
2010; Kargar and Ahmadi 2013). Subsequently, the probability to overcome the threshold size for
product innovation rises with firm size.
The second factor considered is cannibalization, which refers to the situation when an incumbent
firm creates competitors to its own established products after a new or improved product is invented.
It is a fact that fear of cannibalization will hinder product innovation. For instance,3 as creator of the
first digital camera, Kodak did not focus on digital cameras considering the effect on its film business.
This leads to the concern about self ‘creative destruction’, or replacement effect, due to the high sub-
stitutability between new or improved products and established products (Arrow 1962; Tirole 1988).
Tang (2006) finds that easy substitution of products is negatively associated with R&D or product
innovation according to the Statistics Canada 1999 Survey of Innovation data. Cannibalization
fears could be overcome only when the profits from new product lines are high enough so the
loss in existing product lines would be covered in the analysis of monopoly innovation-decision
models (Tirole 1988). Alternatively, with high demand or steep R&D cost functions, firms would
shift the optimal proportion of R&D investment towards product innovation (Rosenkranz 2003). As
a result, startup firms or large firms facing high market demand for new products would be the
 ECONOMICS OF INNOVATION AND NEW TECHNOLOGY 5

ones to overcome the cannibalization and invest in product R&D. To be more specific, large firms
have a greater pool of consumers who would possibly switch from their own established products
to new products, resulting in a higher demand for their new products and thus higher returns to
product R&D. With both threshold size and cannibalization effect considered, gaining in size will
encourage firms to engage in product innovations.
Demonstrating the innovation choice as a function of firm size, the model in Appendix A shows
with an optimal allocation of R&D resources, the cannibalization effect would depress the demand for
existing products and profits from process innovation, in favor of new or improved products. The loss
in process innovation and gain in product innovation will be larger for large firms due to their bigger
market share compared to their smaller counterparts. Therefore, cannibalization can twist the inno-
vation orientation of large firms by discouraging them from devoting relatively more resources to
process innovation. Furthermore, for the group of large firms with excessive cash flow, the choice
of product innovations over process innovations might be further enhanced. As a result, the pro-
portion of product innovations would not decrease as much for large firms compared to the predic-
tion in the literature, or even increase if the effects are strong enough.
Considering the conflicting strengths working in different directions, this paper proposes a non-
linear and non-monotonic pattern: when firms are small, the proportion of product innovation would
rise before threshold sizes for a group of new products are crossed consecutively. After a maximum is
reached at a specific size, it falls gradually when scale advantage strengthens and dominates. The
decline is expected to be weakened by the offsetting effect from cannibalization.

3. Empirical model
The empirical part focuses on modeling a nonlinear relationship of a firm’s innovation choice and firm
size. A-10 (Appendix A) shows that different innovation choices lead to different shares of new pro-
ducts in the total sales, which vary with firm size. Process innovation is applied towards sales of exist-
ing products (Cohen and Klepper 1996a) and the success will lower the production cost and raise the
competitiveness of existing products in the market. Therefore, the proportion of new product sales in
total sales is able to represent the successful investment of product innovations over process inno-
vation. Similar to the pattern of the relationship between the proportion of product innovation and
firm size, a nonlinear and non-monotonic inverted U-shaped relationship between the share of new
product sales and firm size is expected.

3.1. Data
Firm-level data from the Mannheim Innovation Panel Manufacturing and Mining & Services survey
(MIP) that covers the years from 1993 to 2016 is used in the estimation procedure. The surveys
were conducted annually by the Center for European Economic Research (ZEW) and focused on all
firms located in Germany that have at least five employees and are active in the manufacturing
and mining sectors. The data is an unbalanced panel with 10 broad industry categories according
to the German WZ93 classification for manufacturing and mining industries from year 1992 to
year 2015. Participation in the survey is on a voluntary basis and the response rate is about 26.6%
(Peters and Rammer 2013).
In the survey, firms reported the proportion of new or markedly improved products in total sales
(new product sales ratio). A firm with a zero new product sales ratio is treated as having no product
innovations. As shown in Tables 1 and 2, for all the 65,182 observations used in the regression, there
are 31,875 observations with product innovations, 48.9% of the full sample. In contrast, about 39.2%
of the observations have process innovations. Box Plots of new product sales ratios of each industry
(Figure 1) show that Mining has the lowest average new product sales ratio and highest standard
deviation. Chemicals, Machinery, Electrical Equipment, Medical and other Instruments, and Transpor-
tation Equipment seem to be active in product innovations. Mean firm size is 368 full-time employees
6 X. FANG ET AL.

Table 1. Sample statistics.a

Number of Average new product Average firm Average number of
Industry observations sales ratio sales employees
Mining, energy 10,341 0.06 103.1 321.0
(0.17) (1606.7) (6523.9)
Food, tobacco, textiles 8076 0.15 50.3 143.9
(0.25) (309.5) (425.7)
Wood, paper, furniture, 11,664 0.22 53.8 178.0
medical, leisure (0.30) (309.5) (1085.4)
Chemicals 3999 0.25 308.8 716.1
(0.27) (2293.8) (5671.4)
Plastics 4009 0.22 51.1 171.8
(0.29) (218.1) (982.5)
Glass, ceramics 2766 0.18 74.8 259.2
(0.27) (474.5) (1498.3)
Metals 8355 0.16 102.0 298.5
(0.25) (1299.9) (3736.8)
Machinery 7427 0.34 121.3 392.4
(0.32) (529.4) (1747.8)
Electrical equipment 5633 0.33 187.1 622.5
(0.31) (1713.6) (6255.2)
Transport equipment 2912 0.29 620.0 1457.2
(0.32) (4145.0) (9298.5)
Total 65,182 0.21 128.4 367.96
(0.29) (1430.8) (4309.6)
a
The numbers in (.) are the standard deviations.

for all manufacturing industries. The new product sales ratio versus deciles of firm size for each indus-
try is plotted as Figure 2. Most industries exhibit positive relationships between firm size and the new
product sales ratio. However, to control for the confounding effects of other variables, multivariate
regressions are needed to derive the effects of an increase in firm size on new product sales ratios.

3.2. Econometric model

The new product sales ratio will be estimated in the reduced form as a nonlinear function of firm size
controlling for other factors and an inverted U-shaped curve with a long right tail is predicted.
In order to protect the privacy of participating firms, instead of recording a specific value for the
new product sales ratio variable, a range is quoted within which the value of the company lies. The
variable is measured by discrete values from 0 to 9.4 The medians of the intervals are used as the
dependent variable, i.e. new product sales ratio, denoted as new product sales ratio:
new product sales ratio = new product sales/sales (1)
where new product sales denotes the sales from new and improved products, and sales represents the
total sales of the firm. Appendix A shows that the new product sales ratio represents a firm’s inno-
vation choice of product innovations over process innovations.
The number of employees is used to represent the size of firms (size). In the literature, there are
various measures for firm size to serve different purposes. A personnel measure of size is more

Table 2. Summary statistics.

Variable Number of observations Mean Std. Dev. Min Max
New product sales ratio 49,479 0.21 0.29 0 1
Size 65,162 368 4310 0 626,911
proc_innov 16,652 0.432 0.495 0 1
rd_intensity 34,073 0.04 0.05 0 0.15
empl_edu 48,683 0.18 0.23 0 1
HHI2005 46,364 62.24 83.07 2.850 238.2
avg_plc 15,608 14.83 10.98 0 30
 ECONOMICS OF INNOVATION AND NEW TECHNOLOGY 7

Figure 1. Box plots by industry.

frequently used in the studies of innovation (Damanpour 1992; Fritsch and Meschede 2001; Stock,
Greis, and Fischer 2002; Shefer and Frenkel 2005, to name a few). We chose this measure here as
opposed to sales to avoid a mechanical relationship between sales and new product sales ratio,
since the dependent variable has the sales component in the denominator. A log or polynomial trans-
formation is also used in the Hurdle Model because a curvilinear relationship might better represent
the relationship between size and innovation (Damanpour 1992).
Since innovation effort has a direct impact on the innovation output, including the types of inno-
vation (Ghosh 2009; Baumann and Kritikos 2016), R&D investment as a share of total sales (rd_inten-
sity) is included in the regression. The education level of employees is included to represent the
absorptive capability by the proportion of all employees who have a university degree or other
higher education qualifications (empl_edu). The various impacts of these two variables on the new
product sales ratio remain to be decided by the estimation. Success of process innovation (proc_in-
nov) is also included in the estimation as a dummy variable, which equals 1 if the firm has process
innovations, and 0 otherwise. A positive sign of the variable would suggest a positive impact of
success process innovation on product innovation.
An important explanatory variable is market structure or competition. Nelson, Peck, and Kalachek
(1967) argue a highly concentrated industry with diluted competition and reduced number of inde-
pendent decision units might ‘limit the chances of a new idea getting trial and reduce pressure on
R&D’. Link (1982) finds an increasing share of process R&D with higher market concentration in indus-
tries with intensive R&D. Similarly, Scherer (1965) and Kamien and Schwartz (1976) suggest
8 X. FANG ET AL.

Figure 2. New product sales ratio with firm size in deciles by industry.

competition will accelerate the new product innovation. Vives (2008) find that lowering the entry bar-
riers and increasing the number of firms tends to encourage product innovations and depressing
process R&Ds. Others (Levin et al. 1987; Audretsch and Acs 1991; Dubey and Wu 2002; Tang 2006)
found little empirical evidence about the role of market competition in the determinant of R&D
efforts. Given the restrictions of data, we attempt to investigate the impact of competitive pressures
by using the 2005 Herfindahl-index (HHI2005) of industry sales concentration from reports of the
German Federal Statistical Office as the measure for market competition.
Product life cycle is generally included in the innovation choice model (Klepper 1996). As found in
Tang (2006), quick obsolescence boosts product innovation but depresses process innovation. Similar
arguments are found in Fritsch and Meschede (2001), where a negative relationship between the
length of product life cycle and product innovation is suggested because longer product life
cycles imply lower market pressures for a new product to be invented. The average life cycle of
the main product (avg_plc) is used as the measure in our econometric model and a negative sign
is expected.
We also acknowledge that the deepening, or creative accumulation might exist, where innovator
firms continue to innovate and accumulate knowledge (Breschi, Malerba, and Orsenigo 2000). Peters
(2009) finds that innovation behavior is permanent at the firm level and that past innovation experi-
ence and knowledge provided by skilled employees serve an important role for both manufacturing
and service sector firms. We therefore propose a dynamic model by including lagged innovation vari-
ables to incorporate this spillover effect.
Other possible missing variable issues are considered too. Age of firms, a firm’s productivity in
process and product innovation and other shocks to new product sales are usually important in esti-
mating a variable related to productivity. However, due to the data limitation, intermediate products
or R&D investments towards new products are not available as proxies for productivity shocks. An
estimation of the firm size coefficient would be biased if shocks have differential effects for firms’
new product sales ratio with different sizes.
 ECONOMICS OF INNOVATION AND NEW TECHNOLOGY 9

Fixed effect dummies for 24 years and 10 industries are included to control for time and industry-
specific factors, e.g. industry-wide technology advances that are assumed exogenous in contrast to
individual firm advances. Letting k represent individual firms, i index industries, t stand for time, vari-
ations of the following model will be estimated:
new product sales ratiokit = f(sizekit , proc innvkit , rd intensitykit , empl edukit , HHI2005 , avg plckit, ) (2)
Sample statistics of variables included are provided in Table 2.

3.3. Estimation methods

As discussed in the empirical model, small firms do not invest in product R&Ds if their sizes lie below
the threshold sizes. A firm size increase raises the probability of product innovation successes. For
firms over the hurdle (threshold size) and coordinating both types of innovations, larger firms
become more process oriented, resulting in a negative coefficient for firm size. This type of relation-
ship justifies the usage of Hurdle Model, or two-tiered model (Wooldridge 2002, 536–538) that allows
estimation of the two effects separately. The size is log transformed to reduce the skewness in the
firm size distribution and to fit the model better (Damanpour 1992; Stock, Greis, and Fischer 2002).
Considering the possible correlation between process and production innovation, we performed
the Durbin–Wu–Hausman test for endogeneity for the reduced form. The results show no statistically
significant residues (at 1% level).
The estimation proceeds in two steps. First, the effect of size on overcoming the product inno-
vation threshold sizes will be estimated. A positive sign of γ1, the coefficient of interest in (3),
would imply that firm size increase will raise the chances of product innovation success.
P(new product saleskit = 0|Xi )
= 1 − f(g0 + g1 lg sizekit + g2 proc innovkit + g3 rd intensitykit
+ g4 empl edukit + g5 HHI2005 + g6 avg plckit + 1kit ) (3)

where Xi stands for all the explanatory variables.

In the second step, an estimation of the effect of firm size on new product sales is conditioned on
firms having positive new product sales. In the settings, log normal distributions for the variables are
assumed. The coefficient for size will reveal the innovation choice with size increase after firms over-
come the product innovation hurdles. This part, as shown in (4), is estimated using OLS regression.
log (new product sales ratiokit )|(Xi , new product sales ratiokit . 0)
= b0 + b1 lg sizekit + b2 proc innovkit + b3 rd intensitykit + b4 empl edukit + b5 HHI2005
+ b6 avg plckit + 1it (4)

As an alternative to the Hurdle model, Quasi Maximum Likelihood Estimation of Papke and Wool-
dridge (1996) (QLME) is adopted given that the dependent variable is a fraction between zero and
one and there are a large proportion of zeros of dependent variables. To estimate the hypothesized
inverted U-shaped relationship between firm size and new product sales ratio, the squared term, i.e.
size2, is also included to capture the possible nonlinearity and non-monotonicity:
E(new product sales ratio|sizekit = G(b0 + b1 sizekit + size2kit + b3 procinnovkit
(5)
+ b4 rdintensitykit + b5 empledukit + b6 HHI2005 + b7 avg plckit )

where G(.) is a cumulative distribution function which fits the limit dependent variable situation.
Logistic function (logit) and standard normal cumulative distribution (probit) function forms for G(.)
have both been attempted. However, the results are not significantly different, therefore we only
report the results for the Probit function form. Heterogeneity is controlled through robust standard
errors to avoid the effects of possible variance misspecifications.
10 X. FANG ET AL.

Time plays a role in the determination of innovation. We follow the findings of Breschi, Malerba,
and Orsenigo (2000), Peters (2009), and the dynamic estimation strategy proposed by Wooldridge
(2005) that modeled the distribution of the unobserved effect conditional on the initial values and
any exogenous explanatory variables. We use the unbalanced panel to estimate the new product
sales ratio as a function of firm size and other factors considered in the static estimation plus the
changes in all those variables over time to account for the persistence of the effects of innovations
by including the lagged new product sales ratio (new product sales ratiokit−1). The data show gaps in
the years, which reduce the number of observations for the dynamic estimations as we only lag suc-
cessive years. Still, the unbalanced panel sheds some light on the dynamic importance of firm size on
innovation.
The empirical tests are organized in the following order: Hurdle model is estimated first, and then
followed by QMLE (Probit). Including empl_edu significantly reduces the number of observations.
Therefore, models excluding this variable are run as well. Then dynamic models including persistent
effects of innovations are estimated finally.

3.4. Results
Table 3 shows the Hurdle Model estimation results. Probit regressions as the first part of the Hurdle
Model yield positive and significant coefficients for the size variable, representing a positive marginal
effect of size on firms’ chances of success in product innovation. The second part of Hurdle Model
shows that the size effect on proportion of new products is negative and statistically significant
for firms with product innovations. Marginal effect calculations show, on average, one percent
increase in number of employees raises possibility of product innovation success by 0.03. For firms
with new products, new product sales ratio will be lowered by 0.0004. Success of process innovation
raises the probability of product innovation success by 0.27 and new product sales ratio by 0.0012.
R&D intensity, representing the R&D engagement, seems to contribute more than proportionally to
product innovations, which is consistent with the finding of Baumann and Kritikos (2016). HHI has a
negative impact on both chance of product innovation success and proportion of new products in
total sales. The proportion of highly educated employees has no significant impact on innovation
outcomes. The longer average product life cycle of major products significantly lowers not only

Table 3. Estimation results of hurdle modela.

Probitb OLS of Log-Normalc Probitd OLS of Log-Normale
Variable (Hurdle I) (Hurdle II: Robust) (Hurdle I) (Hurdle II: Robust)
lgsize 0.16*** −0.04*** 0.16*** −0.02***
(0.02) (0.01) (0.02) (0.01)
proc_innov 1.41*** 0.12*** 1.60*** 0.12***
(0.06) (0.02) (0.13) (0.02)
rd_intensity 23.99*** 1.51*** 23.96*** 1.86***
(2.17) (0.18) (2.90) (0.24)
empl_edu – – −0.00 0.00
(0.00) (0.00)
HHI2005 −0.01*** −0.00*** −0.01** −0.00
(0.00) (0.00) (0.00) (0.00)
avg_plc −0.02*** −0.02*** −0.02* −0.02***
(0.00) (0.00) (0.00) (0.00)
constant −0.10*** 3.58*** −0.85*** −0.78***
(0.24) (0.07) (0.30) (0.07)
# of observations 6573 4379 3841 2544
a
The quantities in (.) below estimates are the standard errors here and after.
***p < 0.01, **p < 0.05, *p < 0.1.
b
Part I of Hurdle Model: Probit (with binary dependent variables) regression.
c
Part II of Hurdle Model: Log-Normal Robust regression.
d
Part I of Hurdle Model: Probit (with binary dependent variables) regression.
e
Part II of Hurdle Model: Log-Normal Robust regression.
 ECONOMICS OF INNOVATION AND NEW TECHNOLOGY 11

the possibility of new products, but also the new product sales ratio. Most estimated coefficients are
consistent with the hypothesis and predictions.
In the dynamic models shown in Table 4, the lagged new product sales ratio shows a positive and
significant impact on both possibility of product innovation successes and share of new products in
total sales. Our findings agree with Peters (2009) in that innovations are persistent and can create
spillovers into the future. Other estimates are not greatly affected in terms of the signs and statistical
significances. Therefore, our estimates in the previous model are robust to the changes of a dynamic
specification.
QMLE (probit as the link functions in Generalized Linear Model) estimation results are shown in
Table 5. Although the negative sign of squared size coefficients indicates new product sales ratio
will drop after a certain level of firm size, the coefficients are not statistically significant at 10%
level, except for the regression incorporating the effects of employees’ education level (empl_edu)
without the dynamic effects of previous year’s innovations. The Sasabuchi–Lind–Mehlum (SLM)
test (Dhanora, Sharma, and Jose 2019) shows an inverse U-shape, with a large maximum.
However, the non-monotonicity is not supported by empirical evidence in all other pooled
regressions. As for the significant regression, the new product sales ratio starts to fall only for extre-
mely large firms with over 523,000 employees (183,000 in the dynamic model) if the maximum point
does exist.
Similar to Hurdle model, lagged term for new product sales ratio is positive and significant, showing
a persistent pattern of innovations in the past year. Moreover, process innovations benefit product
innovations, by increasing the new product sales ratio by 0.24 on average. The positive coefficient
also signifies that success in process innovations in the same time period can help with new
product development and the sales of new product will expand faster than existing products. R&D
intensity still boosts the product innovation relatively more. The proportion of highly educated
employees still shows no significant impact on innovations. The coefficient for HHI is still negative,
but small in magnitude. One more year of average product life cycle would lead to an average of
0.01 percentage point drop of new product sales ratio.

Table 4. Estimation results of hurdle model-dynamica.

Probitb OLS of Log-Normalc Probitd OLS of Log-Normale
Variable (Hurdle I) (Hurdle II: Robust) (Hurdle I) (Hurdle II: Robust)
lag_new product sales ratio 1.41*** 0.49*** 1.61*** 0.58***
(0.11) (0.02) (0.22) (0.02)
lgsize 0.11*** −0.03*** 0.13*** −0.03***
(0.03) (0.01) (0.05) (0.01)
proc_innov 1.36*** 0.07*** 1.74*** 0.05
(0.06) (0.02) (0.26) (0.03)
rd_intensity 21.83*** 0.71*** 27.32*** 0.75***
(2.30) (0.20) (4.32) (0.28)
empl_edu – – −0.00 −0.00
(0.00) (0.00)
HHI2005 −0.01** 0.00 −2.08** 0.00
(0.00) (0.00) (0.04) (0.00)
avg_plc −0.11** −0.01*** −0.01 −0.01***
(0.00) (0.00) (0.01) (0.00)
constant −0.17 −0.62*** −0.37 −0.06
(0.46) (0.10) (0.72) (0.09)
# of observations 2799 1875 1848 1061
a
The quantities in (.) below estimates are the standard errors here and after.
***p < 0.01, **p < 0.05, *p < 0.1.
b
Part I of Hurdle Model: Probit (with binary dependent variables) regression.
c
Part II of Hurdle Model: Log-Normal Robust regression.
d
Part I of Hurdle Model: Probit (with binary dependent variables) regression.
e
Part II of Hurdle Model: Log-Normal Robust regression.
12 X. FANG ET AL.

Table 5. Qmle results.a

Variable QMLEb QMLEc (Dynamic) QMLEd QMLEe (Dynamic)
lag_new product sales ratio – 1.40*** – 1.51***
(0.06) (0.08)
size (1000 employees) −0.00 −0.01 0.01 0.00
(0.00) (0.01) (0.01) (0.02)
size 2
0.00 0.00 −0.00** −0.00
(0.00) (0.00) (0.00) (0.00)
proc_innov 0.66*** 0.50*** 0.68*** 0.52***
(0.02) (0.04) (0.03) (0.05)
rd_intensity 6.60*** 4.35*** 6.77*** 4.87***
(0.23) (0.35) (0.30) (0.46)
empl_edu – – 0.00* 0.00
(0.00) (0.00)
HHI2005 −0.01*** −0.00*** −0.01*** −0.00***
(0.00) (0.00) (0.00) (0.00)
avg_plc −0.02*** −0.01*** −0.02** −0.01***
(0.00) (0.00) (0.00) (0.00)
constant −0.78*** −0.51*** −0.87*** −0.81***
(0.12) (0.16) (0.15) (0.19)
# of observations 6573 2799 3841 1848
a
Note: The quantities in (.) below estimates are the OLS standard errors or, for
QMLE, the GLM standard errors robust to variance misspecification.
***p < 0.01, **p < 0.05, *p < 0.1.
b
QMLE (Probit) regression.
c
QMLE (Probit) regression with dynamic components.
d
QMLE (Probit) regression.
e
QMLE (Probit) regression with dynamic components.

4. Conclusion
Firm size is usually associated with market power in policy discussions, and concentrated market with
large firms would likely lead to antitrust concerns. In the literature, large firms are viewed as being
more innovative, although more focused on cutting costs rather than developing new products.
This study shows some interesting evidence of the opposite by considering threshold size, the can-
nibalization effect and financial constraints in modeling the relationship between a firm’s internal
allocation of process and product R&D and its size. Existence of a threshold firm size for profitable
product innovation leads to the possibility of zero investment, and a size increase is likely to help
a firm overcome the hurdles and succeed in product R&D activities. In addition, cannibalization
together with possible excess cash flows can create disincentives for large firms in process inno-
vation, and encourages more product innovations.
Composition of a firm’s sales between new and established product sales can reflect its innovation
investment choice and outcomes, and is therefore related to firm size. This paper suggests that prob-
ability of product innovation increases with firm size when firms are small due to the threshold size
effect. When the threshold size is reached, the share of new products in total sales tends to fall with a
further firm size increase. Accordingly, the empirical model employs nonlinear techniques to test the
hypothesized non-monotonic relationship, which is supported by the MIP survey data. However,
given the calculated size at the maximum, only very few large firms are able to reach this stage
and the predicted decline of new product sales in total sales is very small. Moreover, in the QMLE
models, the negative sign for squared term of firm size is not statistically significant in most
regressions, providing relatively weak evidence of non-monotonicity. Therefore, a firm size increase
is on average associated with larger proportion of new product, which implies that large firms might
be more focused on developing new products as opposed to cutting costs.
The estimates for the impact of market competition, however, are consistent with the classical
forecast in that market power measured by concentration ratio has a negative impact on product
innovation prevalence. Therefore, in terms of policy implications, we provide some empirical
 ECONOMICS OF INNOVATION AND NEW TECHNOLOGY 13

evidence to support the current government policies that favor large R&D investments, such as sub-
sidies, government funding, tax credits or benefits toward R&D expenses, as well as relaxing the anti-
trust laws to encourage research consortia or cooperation among a group of firms. For industries
where product innovations are preferred, these policies could help firms to spread out R&D costs,
control risks, raise funds and increase size of potential market for new or improved products
which are major barriers for product R&Ds. Also, it might not be desirable to break a large firm
into small pieces for industries that favor product innovation, but to foster competition by supporting
more start-ups and firm growth.
A positive spillover from the product innovation in the past year is detected. Process innovation
in the same year is associated with a more than proportionate increase of product innovations rep-
resented by the new product sales ratio. In view of the positive effects, continuous R&D invest-
ments in both types of innovation could be beneficial to a firm with an emphasis on
developing new or improving products. The length of product life cycle is inversely related to
the emergence of new products, which is intuitive and signified the need for a business to
invest in product R&Ds. Our results also imply that industries with intensive R&D activities
usually favor product inventions over cost reductions, which agrees with the idea that firms
should structure their R&D trying to diversify their product and process innovations (Dhanora,
Sharma, and Khachoo 2017).
In summary, in the study to re-evaluate the relationship between proportion of product inno-
vation and firm size, we find that a market with large firms but stays competitive would be desirable
in the sense of bringing more new products into existence. We recognize the constraints of survey
data. Innovation outcome, as a measure of R&D resource allocation, is not perfect and restricts the
implications we can draw regarding a firm’s decision process. Our findings are also limited for not
able to include some important factors, such as the age of the firm, R&D funding source, R&D
cooperation, etc. Future research on the impact of financing sources, dynamic relationship
between firm size, innovations and firm performances/exiting behaviors could bring more impli-
cations if a balanced panel with more variables become available.

Notes
1. Scheck and Glader 2009.
2. Tirole 1988.
3. Kodak Says It Will Stop Making Digital Cameras, The Associate Press. New York Times, New York, N.Y.: Feb 10, 2012.
pg. B.1
4. 0: 0% 1: <5% 2: <10% 3: <15% 4:<20% 5: <30% 6: <50% 7:<75 8:<100% 9:100%

Acknowledgement
We acknowledge the data support from the Center for European Economic Research (ZEW). We are grateful to Dr. Richard
Peck, Dr. Joshua Linn, Dr. Houston Stokes, Dr. Helen Roberts, and Dr. Margaret S. Loudermilk for their invaluable sugges-
tions and unwavering encouragement. We would also like to thank Prof. Ken Schoolland for his editorial assistance that
greatly improved the manuscript.

Disclosure statement
No potential conflict of interest was reported by the authors.

ORCID
Xin Fang http://orcid.org/0000-0002-5731-3361
Noelia R. Paez http://orcid.org/0000-0002-2654-4407
Bei Zeng http://orcid.org/0000-0003-1277-1665
14 X. FANG ET AL.

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Appendix

Firms are assumed to benefit from process innovations mainly through their ex ante output. Process innovations lower
production costs, while product innovations raise the price of new or improved products. Both innovations raise the
price-cost margin. Cannibalization cannot be incorporated in Cohen and Klepper’s work due to their perfect competition
setup. However, in a monopolistic competition market with capacity constraint and stair case demand for a firm, canni-
balization is possible. Firms’ positive profits created by innovations are assumed to be temporary. The ex-ante quantity
(quantity before innovation) is denoted as q. The two types of R&D investment, and related variables are distinguished by
subscripts, with 1 denoting process-related variables and 2 product related. Investments of process R&D are represented
by ri, and pci(ri) stands for the price- average cost margin thanks to the investments. In Equation (A1), the profit function
for process innovations, pc1(r1) denotes the new price-average cost margin resulted from a decrease in the average cost
due to process innovation, specifically. As the profits only exist for a certain period and then disappear, ai is used as the
length of time before the profits disappear, that is, for the length of time before the new process or product is imitated.
Proportion of consumers who switched to new products is denoted as h, leaving the base of process innovation to be (1
−h)q, representing cannibalization effect. Demand for new or improved products increased by hq. The profits from
 ECONOMICS OF INNOVATION AND NEW TECHNOLOGY 17

process R&D is:

p1 = a1 (1 − h)qpc1 (r1 ) − r1 (A1)

‘Cannibalization’, h, bounded by (0,1) will lower the returns to process innovation. Given the same level of cost
reduction, reduction in total cost is larger with higher output level. In the presence of cannibalization, output of estab-
lished products falls, and the returns to process innovation is depressed. In terms of product innovation, returns to
product R&D are given by the function employed by Cohen and Klepper (1996a):
p2 = a2 (hq + K)pc2 (r2 ) − r2 (A2)
where K denotes the output sold to new consumers.
−(1/bi )
pc′i (ri ) = bi ri i = 1, 2 (A3)

where bi stands for the rates at which the marginal returns to process and product R&D decline, and bi represents
industry level technological opportunities for type i R&D. This form guarantees pci′ (ri) > 0 and pci′′ (ri) < 0 for all ri ≥ 0.
Therefore, innovation is treated as production subject to decreasing marginal returns. We assume that the marginal
returns to process innovation declines no faster than product innovation (β1 ≥ β2) because it is much harder for the
price increase due to higher quality to remain increasing at high speed than to keep cutting the costs down by
invest in process R&D. In addition, βi is assumed to be greater than one so the marginal cost is reduced and price
(value) for new products are positive. This assumption leads to the conclusion that R&D investments will rise more
than proportionally to firm size that can be shown in optimal R&D investment solutions. This assumption is not
against empirical evidence (Baldwin and Scott 1987).
F.O.C. for an optimal allocation of R&D investments are derived as the following expressions:

r1 = f [(1 − h)q]b1 (A4)

r2 = g(hq + K)b2 (A5)

b1 b2
where f = (b1 a1 ) and g = (b2 a2 ) . If the ratio of the two optimal levels of R&D investments is taken, R is obtained:

f [(1 − h)q]b1
R= (A6)
g(hq + K)b2

Then R is differentiated with respect to q, the ex ante firm size:

∂R fgqb1 −1 [(1 − h)]b1 (hq + K)b2 −1 [(b1 − b2 )hq + b1 K]

= (A7)
∂q [g(hq + K)b2 ]
2

∂R
Provided that β1 ≥ β2, will be positive, that is, an increase in size raises the proportion of process R&D relative to
∂q
product R&D. In contrast to Cohen and Klepper (1996a) as shown in Equation (A8), the impact of size on share of process
R&D is smaller due to (1 − h)b1 , 1 (Cohen and Klepper 1996a).

∂R fgqb1 −1 (hq + K)b2 −1 [(b1 − b2 )hq + b1 K]

= (A8)
∂q [g(hq + K)b2 ]
2

This indicates the comparative advantages of larger firms in process innovations decline due to cannibalization.
Therefore, the proportion of R&D resources devoted to process innovation should be smaller for larger firms, all else
equal.
To form the theoretical prediction for the relationship between firm size and ratio of new product to the established
product sales on which process innovation is applied, it is equivalent to examine the relationship between firm size and
sales ratio of new product sales in total sales. Let TR1 denote the sales from established products, and TR2 denote the
sales from new products, p1 denote the price of established product while p2* denote the price for new product
during the transition period. We have the sales ratio of established products to new products as shown in Equation (A9):


1
a1 p1 (1 − h)q 1 −
TR1 a1 p1 (1 − h)q b2
= = (A9)
TR2 a2 p∗2 (hq + k) [a2 b2 (hq + k)]b2

After taking the first derivative of the ratio with respect to ex ante firm size q, we have:
∂(TR1 /TR2 ) a1 p1 (1 − h)(b2 − 1)[hq(1 − b2 ) + k]
= (A10)
∂q (a2 b2 )b2 (hq + k)(1+b2 )
18 X. FANG ET AL.

By assumptions, we know that β1 , β2>1. If condition as shown in (A11) holds, the ratio of sales from existing products
to new or markedly improved products will increase with firm size, new product sales ratio will fall with firm size.
k
k . hq(b2 − 1) or .1 (A11)
(b2 − 1)hq
k/(b2 − 1)hq can be interpreted as a measure for comparative advantage of smaller firms in product innovation (or com-
parative advantage of larger firms in process innovation). The same change in k (quantity of new products purchased by
new consumers) or q (ex ante output) will affect the returns to innovations the same way for different firm size.
However, β2, has an impact on the total quantity demanded created for new products, implying a larger marginal
benefits effect for larger firms. This is because the quantities purchased by consumers who switched from existing
pool tend to be higher for larger firms, while the quantities from new consumers are the same. As a result, the quantity
demanded created for larger firms is higher. When β2 becomes smaller, or the measure becomes larger, larger firms will
lose more marginal benefits in product innovation, and relative advantage in process innovation will be enhanced.
In addition, h in the denominator is the proportion of consumers who contribute to the demand for new or improved
products. If h decreases, the fraction (measure) will increase, and larger firms tend to have smaller reduction in the mar-
ginal benefits for process R&D, accompanied by smaller increase in marginal benefits for product R&D because the
demand from switched consumers is less. Therefore, if the measure increases, the greater the comparative advantage
of larger firms has in process innovation (or greater comparative advantage for smaller firms in product innovation).
If this measure is greater than one, or the comparative advantage of large firms in process innovation is sufficiently
high, large firms would have smaller proportions from new or improved products. It is equivalent to say, smaller firms
are more intensive in new product sales.