What factors drive innovation performance in a developing country context? : a panel research testing the influence of institutional voids on the relationship between R&D, FDI, and international trade in enhancing innov

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What factors drive innovation performance in a developing country

context?

A panel research testing the influence of institutional voids on the relationship between R&D, FDI, and international trade in enhancing innovation performance

Name: Anne Verhaar

Student number: 10262253

Date: June 23, 2017

Qualification: MSc. in Business Administration – International Management track Institution: Amsterdam Business School, University of Amsterdam

First reader: Dr. Mashiho Mihalache Second reader: Dr. Niccolò Pisani Word count: 18.052

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Statement of originality

This document is written by student Anne Verhaar who declares to take full responsibility for the contents of this document.

I declare that the text and the work presented in this document is original and that no sources other than those mentioned in the text and

its references have been used in creating it.

The Faculty of Economic and Business is responsible solely for the supervision of completion of the work, not for the contents.

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List of Figures

Figure 1: Theoretical Framework...32

Figure 2: Overview of the Results...48

List of Tables

Table 1: Summary Variables ...39

Table 2: Correlation Coefficients...41

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Abstract

As the global economy is becoming more dynamic, the concept of innovation appears to be rising as an important determinant enabling multinational enterprises (MNEs) to

advance their existing business activities. Not surprisingly, research exploring the factors behind innovation has experienced significant growth, leading to three predominant justifications, which concern the role of research and development (R&D), foreign direct investments (FDI), and international trade (i.e. import and export). Even though the literature concerning R&D, FDI, and international trade has contributed significantly, progressing our knowledge on what drives innovation, limited studies have examined the way in which these constructs apprise each other. This thesis, therefore, aims to further explore the joint effects of R&D, FDI, and international trade to provide more clarity on what determines innovation. Furthermore, this framework will be tested in a developing country context, as current globalization patterns indicate that Western MNEs are increasingly expanding towards developing countries. However, as little research is available on innovation in developing countries, this warrants for the investigation thereof. Besides that, as it is recognized that Western MNEs struggle to compete due to the poor institutional quality in developing countries, this research investigates whether weak institutions hinder innovation.

Using a sample of 49 developing countries, this research shows empirical support for the direct effects of assessed drivers of innovation in generating innovation performance within developing countries. Besides that, this study has found partial empirical support concerning the moderating role of institutional quality. Specifically, it was illustrated that poor business sophistication in developing countries weakens the enhancement of innovation performance, derived from R&D and FDI.

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1. Introduction

In today’s economy, innovation is considered as a fundamental driver for enhanced economic growth and development (Qu, Qu & Wu, 2017). As the world is characterized by increasing competition and economic expansion, economists have acknowledged that innovation is evolving towards an essential construct to generate economic successes (Grossman & Helpman, 1991; Hult, Hurley & Knight, 2004), leading to the general appreciation of the importance of innovation. Innovativeness accredits organizations, industries, and economies to obtain positional advantages and superior economic

performance (Furman, Porter & Stern, 2002). Furthermore, through innovation companies have the opportunity to develop resolutions to business challenges and pressures, providing support to survive and to remain successful in the future (Hult et al., 2004).

Not surprisingly, research in the past decades has been growing tremendously in investigating the forces that drive innovation (e.g. Cheung & Lin, 2004; Liu & Buck, 2007). In understanding how differences in innovation performance develop, three theoretical justifications have been established (Wang & Kafouros, 2009). These justifications include the impact of international trade (Salomon & Shaver, 2005), research and development (R&D) (Zhang, Li, Hitt & Cui, 2007), and foreign direct investments (FDI) (Feinberg & Majumdar, 2001). Each of these factors has been widely recognized as essential in generating innovation (Wang & Kafouros, 2009). Even though these studies have contributed

considerably to advancing theory and knowledge on the determinants of innovation performance, limited research has accommodated these factors into one study (Wang & Kafouros, 2009). While there is a growing interest in advancing knowledge of what drives innovation, separately examining the determinants limits our understanding of how

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provide clarity on the findings regarding innovation; R&D, FDI, and international trade must be analyzed in a unified framework. By integrating all three drivers instead of analyzing them separately, a more thorough understanding of the relations between R&D, FDI, and

international trade can be established (Wang & Kafouros, 2009).

However, as the importance of the concept of innovation advances, the existing literature on innovation performance has been mainly focused on the Western world (Brem & Wolfram, 2014; Ernst, Kahle, Dubiel, Prabhu & Subramaniam, 2015). Given the changing dynamics of the global economy (Ernst et al., 2015), it is striking that limited studies are available concerning the factors that contribute to innovation performance in developing countries (Wang & Kafouros, 2009). Since the start of the 21st century, developing countries have encountered accelerated growth. This development is enhanced through rising levels of FDI, gross domestic product, and salaries across developing countries. Consequently, a tremendous amount of people have moved out of extreme poverty, and up to middle-income classes (Alfaro, Chanda, Kalemli-Ozcan & Sayek, 2004). Given the fact that these middle-income classes in developing countries consist of approximately four billion people, and it is forecasted that they will be responsible for half of total global consumption by 2025

(Atsmon, Child, Dobbs & Narasimhan, 2012), it is likely that demand for new products in these countries will grow the next coming years. Which, in turn, illustrates the importance of innovation in a developing country context.

Accordingly, as the locus of innovation appears to be shifting due to the rise of

developing countries (Govindarajan & Ramamurti, 2011; Li & Kozhikode, 2009), innovation initiatives in developing countries are growing and have become more evident. In

combination with the declining pace of economic growth in developed countries (Atsom et al. 2012), multinational enterprises (MNEs) have increasingly shifted their businesses to less developed countries (Demirbag & Glaister, 2010; Ramamurti, 2012). While MNEs primarily

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entered developing countries to have access to inexpensive labor and natural resources, MNEs are recognizing the potential benefits of moving innovation activities to these

countries (Govindarajan & Ramamurti, 2011). Despite the growing importance of developing countries in undertaking future innovation activities, data show that MNEs are still facing issues to effectively innovate in these countries (Atsom et al., 2015; Brem & Wolfram, 2014; Khanna, Palepu & Sinha, 2005).

The existing literature emphasizes the differences between developed and developing countries (e.g. London & Hart, 2004). While developing countries have been celebrated for their potential in realizing future economic growth, these countries also expose MNEs to significant levels of uncertainty as a result of their unstable business environments (Luo, 2003). Additionally, developed and developing countries can also be distinguished based on various social, legal, and political aspects (Marquis & Raynard, 2015). Due to these

differences, studies question the potential of developing countries to generate the same level of innovation output as developed countries (Goñi & Maloney, 2014). A possible explanation for these lower innovation outputs refers to the poor institutional quality across developing countries (Goñi & Maloney, 2014; Khanna et al., 2005). The effectiveness of a country’s institutional context is argued to be of great importance in undertaking innovative activities (Qu et al., 2017), as institutions provide support regarding additional resources and

knowledge improving innovation initiatives (Allen & Cohen, 1969). The lacking institutional conditions in developing countries, defined as institutional voids, hinder MNEs in the

execution of their innovation activities (Khanna et al., 2005). Subsequently, developing countries are questioned in their ability to efficiently generate innovation performance, given their weak institutional environments (Khanna et al., 2005; Porter & Stern, 2001).

Limited studies have empirically analyzed the rather new and uninvestigated

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2015; Wang & Kafouros, 2009). Additionally, existing literature examined either appropriate strategies to cope with the turbulent business environments in developing countries (e.g. Hoskisson, Eden, Lau & Wright, 2000; London & Hart, 2004) or the institutional

environment in these countries (e.g. Peng, Sun, Pinkham & Chen, 2009). However, little research combined these aspects, investigating the effects of lacking institutional conditions in generating innovation (Brem & Wolfram, 2014; London & Hart, 2004). As the global economy is changing and the importance of innovation continues to rise, it is imperative for MNEs to comprehend whether weak or lacking institutions in developing countries may constrain them in reaching their innovation potential (Khanna et al., 2005). Thus, to fill this gap, the overarching question that this research aims to answer is:

What is the influence of institutional voids on the relation between R&D, FDI, and international trade in generating innovation performance?

This research proposes to shed light on the impact of institutional voids on the effects of R&D, FDI, and international trade determining innovation performance. To increase the knowledge in what governs innovation; this thesis will extend the conceptual framework developed by Wang and Kafouros (2009). It is believed that poor institutional quality in developing countries hinders MNEs in attaining their innovation potential. As a result, it is argued that institutional voids negatively moderate the effects of R&D, FDI, and international trade on innovation performance.

This thesis will contribute to the literature on innovation performance and institutional voids in different ways. First of all, an in-depth analysis of the effects of R&D, FDI, and international trade will be presented, which gives insights on the influence of the three

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aspects of innovation performance. Drawing on cross-country data this research emphasizes the role of R&D, FDI, and international trade in improving innovation performance.

Secondly, as prior research about innovation was mainly based on the Western world (Ernst et al., 2015), this research will particularly analyze the concept of innovation across developing countries. Also, while previous studies on developing countries were either conceptual, qualitative or focused on one country (London & Hart, 2004; Prahalad, 2012; Wright, Filatotchev, Hoskisson & Peng, 2005), this thesis will contribute to the knowledge on innovation analyzing multiple developing countries worldwide. Besides that, the study

applies a longitudinal research design in order to find stronger evidence based on the data. Lastly, this thesis will concentrate on the impact of institutional voids on innovation performance, which requires more scholarly attention. Limited studies have analyzed the moderating effect of institutions concerning innovation performance (e.g. Qu et al., 2017). Qu et al. (2017) investigated the moderating role of regional formal institutions on innovation performance, determined by FDI. However, this study solely concentrated on FDI generated innovation. Furthermore, this research is limited by using a dataset, which only includes Chinese companies. Investigating the moderating role of institutions in another country may lead to different findings. Additionally, when identifying the challenges that may arise from institutional voids in enhancing innovation performance, practitioners become aware of the possible constraints that emerge from the institutional environment across developing countries.

Besides theoretical implications, this thesis also includes managerial contributions and will contribute to MNEs’ knowledge in undertaking innovation activities within developing countries. Improving the understanding regarding the relationship between institutional voids and innovation performance within developing countries provides MNEs with the ability to respond more effectively. When developing countries are characterized by the

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before-mentioned institutional voids, MNEs may decide to collaborate with local firms (e.g. setting up a joint-venture) to mitigate these effects.

This research is structured as follows: firstly, the central theoretical concepts of this research will be described. In this chapter, a general concept of developing countries will be described, and an in-depth review of the literature on R&D, FDI, international trade, and innovation performance will be addressed. Secondly, the definition of institutional voids is provided. Thirdly, the research model and hypotheses are presented in a theoretical

framework, which is supported by the literature. Next, the methodology in this study is presented, describing the collected data. This section outlines the dataset and sample, as well as, descriptions of the addressed variables, their sources, and measurements. Subsequently, an overview of the empirical results is shown. Lastly, the final chapters of this thesis are the discussion and conclusion. In these chapters, an answer is provided to the research question of this thesis. Besides that, limitations regarding this study are discussed, as well as,

suggestions for future research.

2. Literature Review

This chapter will present the literature that serves as the foundation for the empirical analysis of this study. The theoretical debate on the impact of R&D, FDI, and international trade on innovation performance will be reviewed, as well as, the literature concerning the presence of institutional voids in developing countries. Firstly, developing countries are described as a general concept. Secondly, the influence of the identified drivers of innovation (i.e. R&D, FDI, and international trade) on innovation performance is discussed. Finally, theories concerning the relationship between institutional voids and innovation performance are reviewed.

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2.1 Developing Countries

In the past decades, the global economy has changed significantly (Atsmon et al., 2012). As developing countries have opened up their markets, Western MNEs have increasingly turned to these countries to gain access to significant amounts of natural resources, low-cost production facilities, and inexpensive labor (Arnold & Quelch, 1998; Garelli, 2008). Both scholars and practitioners emphasize the fact that developing countries increasingly serve as a foundation for economic success (Atsmon et al., 2012), therefore, giving more attention to the movement of Western MNEs to such countries (e.g. Arnold & Quelch, 1998).

While developing countries were previously referred to as less-developed countries, a new perspective defines their economies as markets, enabling MNEs to grasp their profit potential (Arnold & Quelch, 1998). As such, MNEs no longer solely turn to developing countries for the available, inexpensive production facilities, but also acknowledge their potential as a source of future economic growth (Arnold & Quelch, 1998; Garelli, 2008; Li & Kozhikode, 2009). This phenomenon is emphasized by the fact that the value of inward foreign direct investments (FDI) to developing countries has reached a new high of $765 billion in 2015, which is nine percent higher than in 2014 (UNCTAD, 2016). Developing country consumers increasingly make up a larger share concerning global demand, intensifying the quest for innovation (Atsmon et al., 2012). Subsequently, this growing demand for new products and services creates opportunities for MNEs.

Given the importance of developing countries, it is imperative to have a precise definition of these countries. Developing countries are defined by Hoskisson et al. (2000) as

“low-income, rapid growth countries using economic liberalization as their primary engine for growth”(p.249). In identifying these countries, two criteria must be fulfilled: (1) rapidly

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economic liberalization and the integration of a free-market system (Arnold & Quelch, 1998). Furthermore, Hermelo and Vassolo (2010) stress that the macroeconomic environment in developing countries is more volatile compared to developed countries. Whereas economic cycles of developed countries are continuous and less disruptive, this is not the case in

developing countries. Financial crises in developing countries are not exceptional and emerge regularly, fluctuating from mild recessions to severe economic catastrophes (Calvo, Izquierdo & Talvi, 2006). Nevertheless, it seems that developing countries have a great ability to

recover from these disruptions.

2.2 Innovation

Innovation is considered as an engine for generating economic growth and

development (Grossman & Helpman, 1991). Due to ever-changing customer demands, the evolving global marketplace, and technological development, the quest for innovation is rising (Baregheh, Rowleg & Sambrook, 2009). By intensifying innovation activities, MNEs have the opportunity to improve their economic performance and enhance their positional advantages (Furman et al., 2002). Subsequently, as the global economy becomes more dynamic, a large number of studies have looked into the forces and processes that might enhance innovation (Baregheh et al., 2009; Cheung & Lin, 2004; Liu & Buck, 2007).

In determining the concept of innovation, scholars across different disciplines have defined innovation in various ways (Baregheh et al., 2009). Generally speaking, innovation is perceived as “the lifeblood of corporate survival and growth”(Zahra & Govin, 1994, p.183). As previous studies indicate, innovation is a fundamental mechanism to create value, sustain, and enhance competitive advantages (Baregheh et al., 2009). More specifically, Boer and During (2001) refer to the introduction of a new product or technology, based on market and an organization’s configurations, in defining innovation. Other definitions incorporate

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knowledge when describing innovation. Harkema (2003) indicates that innovation concerns knowledge of the development of new business processes. This refers to the definition of innovation by Du Plessis (2007), which emphasizes that innovation regards the assessment of new knowledge and ideas to enhance positive economic outcomes. Baregheh et al. (2009) define innovation as “a multi-stage process whereby organizations transform ideas into

new/improved products, services, or processes, to advance, complete, and differentiate themselves successfully in the marketplace” (p.1344). All things considered, innovation

involves change and the development of new products, services, and technologies, referring to a broad range of resources, strategies, and competencies (Baregheh et al., 2009).

The examination of the drivers behind innovation has been growing considerably concerning academic and empirical research (e.g. Cheung & Lin, 2004; Liu & Buck, 2007; Qu et al., 2017; Wang & Kafouros, 2009). Among the many influential factors, three predominant declarations have been shown to play a significantly important role (Wang & Kafouros, 2009). These elements include the role of international trade (e.g. Salomon & Shaver, 2005), FDI (e.g. Feinberg & Majumdar, 2001), and R&D (e.g. Zhang et al., 2007). Existing literature recognizes the importance of these three forces in generating innovation output (Wang & Kafouros, 2009). Despite the fact that the studies mentioned above have contributed in progressing the available knowledge on innovation, limited studies, however, have tried to include these three indicators into one framework. Given the comprehensiveness of the concept of innovation, separately focusing on these constructs limits our understanding of how deviations in innovation performance are caused (Wang & Kafouros, 2009).

Analyzing the effects of R&D, FDI, and international trade collectivity (Liu & Buck, 2007) establishes more clarity in what drives innovation (Wang & Kafouros, 2009). As such, a composite measurement provides more information on the individual contribution of each indicator from which results can be explored in more detail.

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The existing literature has investigated the impact of R&D, FDI, and international trade on innovation performance (Feinberg & Majumdar, 2001; Salomon & Shaver, 2005; Zhang et al., 2007), however, most research applied either one of these indicators. Since only one empirical study examined the effects of R&D, FDI, and international trade in a unified framework (Wang & Kafouros, 2009), this study aims to explore further the model proposed by Wang and Kafouros (2009) and builds on the need to investigate what drives innovation, using multiple determinants. Additionally, this research will focus on the direct effects of R&D, FDI, and international trade on innovation. In the following subchapters, the available literature on the addressed drivers of innovation will be analyzed.

2.1.1 Research and Development

R&D can be defined as the exploratory work undertaken by organizations to increase their current knowledge base and apply this to advance the existing products and improve the efficiency of business procedures (Dickson, Stephen & Helen, 2014).

As indicated in previous studies, in the establishment of innovative output MNEs preferably turn to R&D (Mairesse & Mohnen, 2005; Zhang et al., 2007). It is frequently proposed that MNEs invest in R&D to extend their available, scientific knowledge base (Feinberg & Majumdar, 2001; Kafouros & Buckley, 2008; Kafouros, 2008). The obtainment of such intangible knowledge assets supports MNEs in the enhancement of innovation (Mairresse & Mohnen, 2005), and boosts their productivity (Feinberg & Majumdar, 2001). Not surprisingly, statistics show that the amount of global R&D has taken a leap over the past decades (Li & Kozhikode, 2009). R&D investment enables MNEs to increase their internal stock of knowledge. This knowledge, in turn, contributes to MNEs’ initiatives concerning new product design and development (Hagedoorn & Cloodt, 2003). Furthermore, this knowledge also improves existing production processes, diminishes expenses, supports in

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assessing the competitive position, and subsequently enhances the possibility of better economic performance (Kafouros, 2008). Similarly, Zhang et al. (2007) specify that R&D investments allow MNEs to advance their technical skills and broaden their knowledge about the local environment. Besides that, the related indirect impact of R&D indicates that it facilitates improved organizational learning. These indirect effects provide MNEs with the opportunity to develop their knowledge regarding the external environment, offering insights on new technologies and ideas from competitors, which can be exploited for commercial purposes (Buckley & Carter, 2004). Hence, this relation between R&D and innovation implies that R&D constitutes for greater levels of productivity and is capable of converting R&D input (i.e. ideas, knowledge, technology), into innovative output (Penner-Hannh & Shaver, 2005). Additionally, addressing R&D does not only improve the performance of MNEs undertaking such activities but also progresses the performance of other organizations (Kafourous & Buckley, 2008). The development of knowledge through R&D activities may spillover to other firms (Feinberg & Majumdar, 2001). As such, organizations in the domestic environment may exploit this knowledge improving their productivity and innovative

potential as well (Kafouros & Buckley, 2008).

While the arguments above demonstrate support for the relationship between R&D and innovative performance, such results have not always been found. Prior research failed to find similar evidence illustrating a positive, direct relationship between R&D and innovation performance (Damijan, Knell, Majcen & Rojec, 2003; Graves & Langowitz, 1993). For example, Goñi and Maloney (2014) investigated the influence of R&D in generating innovative output across developing countries. From this study, it was concluded that regarding new product development, solely focusing on R&D is not enough, especially in developing countries that lack the sophisticated institutions of developed countries. Likewise, research by Schneider (2005) indicates that R&D does expedite in the establishment of

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innovative activities; however, this is more likely in a developed country context. As such, the ability to enhance innovation performance from R&D could, thus, be questioned due to interaction with the external environment in which MNEs operate (Allen & Cohen, 1996; Barasa, Knoben, Vermeulen, Kimuyu, Kinyanjui, 2017; Schneider, 2005).

Consequently, given the inconsistent findings concerning R&D driven innovation, especially across developing countries, it is interesting to investigate the relationship between R&D and innovation performance further.

2.2.2 Foreign Direct Investments

FDI refer to the investments made by a company or individual in a country outside the home country. FDI takes place through either the establishment of a new business entity (i.e. wholly owned subsidiary) or the acquirement of interest in a foreign business operation (Moran, 2012).

Among the various factors that stimulate innovation, FDI appears to be a significant determinant (Qu et al., 2017). FDI can be regarded as an essential channel in progressing innovation performance, as FDI embodies particular advancements, such as superior technologies (Liu & Wang, 2003; Long, Yang & Zhang, 2015). Antonietti, Bronzini, and Cainelli (2015) exemplify that MNEs are recognized as capable mechanisms through which knowledge, resulting from innovation, can be efficiently transferred between countries, in the form of FDI. This movement, in turn, influences the innovative capacity of organizations that operate in the domestic environment, through flows of labor, knowledge, and by

demonstration effects (Cheung & Lin, 2004; Görg & Greenaway, 2004). Cheung and Lin (2004) indicate that foreign products and technologies encourage innovation stimulating the development of new products and business processes. Similarly, interactions between domestic and international firms, for example, through licensing and technological

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collaboration, may further assist in the execution of innovative activities carried out by national and foreign companies (Scott-Kennel, 2007). Additionally, FDI forces innovative activity, as the degree of competition intensifies through FDI (Branstetter, 2006). Moreover, previous studies illustrate that FDI is associated with spillover effects deriving from products, technologies, and know-how transferred by foreign investors (Feinberg & Majumdar, 2001). Consequently, foreign investments may affect the level of productivity, opportunities, and costs of the firms operating in the host country (Qu et al., 2017). Through learning-by-doing and learning-by-watching domestic firms have the chance to acquire additional knowledge (Lin, Hsiao & Lin, 2015), which can be implemented within these companies improving productivity and innovative capability. Hence, the arguments mentioned above illustrate FDI disseminates knowledge and triggers spillover effects (Branstetter, 2006; Feinberg &

Majumdar, 2001), which can serve as a foundation for the establishment of innovative activities by MNEs.

While the studies mentioned above emphasize a positive relationship between FDI and innovation performance (Branstetter, 2006; Qu et al., 2017), other research did not find such evidence confirming this relation (Harrision & Aitken, 1999). For example, Damijan et al. (2003) suggest that FDI does not provide the opportunity and knowledge to enhance innovation performance, as no evidence was found validating this relationship. Similarly, a study by Haddad and Harrison (1993) could not identify a relationship between FDI and innovation performance.

As previous research does not provide complete clarity on the relationship between FDI and innovation, combined with the fact that innovation continues to rise as a

fundamental concept regarding economic growth, makes it interesting to explore this relationship further.

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2.2.3 International Trade

The third addressed driver of innovation in this research concerns international trade. International trade refers to the movement of goods and services across borders. Previous studies illustrate a positive relationship between international trade and innovation

performance (Liu & Buck, 2007; Wang & Kafouros, 2009). It is argued that the involvement concerning international trade facilitates the development and dissemination of new

technologies and products (Chuang & Hsu, 2004; Liu & Buck, 2007). This research evaluates the effects of import and export separately, in examining the relationship between

international trade and innovation performance.

In investigating the relationship between export and innovation, MacGarvie (2006) suggests that through the participation in export, MNEs have the opportunity to explore the innovation outputs of their foreign counterparts. Export embodies vital knowledge regarding innovation and competitors, which, in turn, could facilitate enhanced levels of productivity (Chuang & Hsu, 2004). Furthermore, it is argued that through exporting, firms can explore newly established technologies and increase their accessibility to diverse knowledge in advancing organizational learning. This also enables companies to generate scalable

innovation output, as they benefit from the competence of their foreign competitors (Blalock & Getler, 2004). Similarly, participation in export increases MNEs’ competitiveness, as the available knowledge about competing products and preferences of the clientele expands (Salomon & Shaver, 2005). Besides that, through exporting, organizations become exposed to competition to a greater extent; as such MNEs may feel urged to invest more in current innovation activities (Kokko, 1996).

Similarly, prior studies propose that importing may also have an impact on innovation (Grossman & Helpman, 1991). Import embodies vast amounts of knowledge, which are transferred across international borders through the movement of goods and services. Kumar

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and Aggarwal (2005) distinguish between embodied and disembodied forms of knowledge that can be imported, referring to scientific knowledge and technologies. Empirical evidence suggests that both forms are applicable when explaining the inclination to innovate.

Furthermore, MacGarvie (2006) points to the connection between importing firms and innovative inventions. Through newly imported products and technologies, MNEs have the ability to advance their innovative efforts by analyzing actions of competitors (Almeida & Fernandes, 2008). Likewise, Kumar and Aggarwal (2005) emphasize the usefulness of imported products, which allow firms to boost their innovative potential in exploring the benefits integrated into such goods.

While the researches mentioned above highlight the potential of international trade in enhancing innovative performance, other studies did not find empirical evidence

acknowledging this relationship. Prior research did not find similar results questioning the contribution of international trade to improving innovativeness (Delgado, Farinas & Ruano, 2002). For example, research by Clerides, Lach, and Tybout (1998) investigated whether exporting was associated with better innovative performance; however, this was not the case. A similar question was addressed in a study by Bernard and Jenssen (1999), in which no relation was found between international trade and innovation performance.

As of this, given the rising importance of innovation in the global economy, it remains important to provide clarity with regard to the relationship between international trade and innovation performance.

2.3 Institutional Voids

As indicated, over the past decades the global economy changed significantly. Mainly developing countries have been identified as locations for future economic growth (e.g. Qu et al., 2017; Xu & Meyer, 2013), attracting more attention from both scholars and practitioners.

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As MNEs are increasingly expanding their geographic scope to developing countries, their business operations become exposed to diverse institutional settings (Marquis & Raynard, 2015). When comparing both developing and developed countries, aside from economic differences, various social, legal, and political aspects, come to light, distinguishing the business environments of both types of countries (Marquis & Raynard, 2015). Even though developing countries have made considerable improvements regarding their general business conditions (Alvarez & Barney, 2014), these countries appear to hinder MNEs in the

execution of innovative activities and the results thereof, due to the role of institutions (Acemoglu & Robinson, 2008). North (1990) emphasizes the fact that MNEs are

significantly affected by the external environment in which they operate. Especially, the institutional environment across developing countries plays a critical role (Hoskisson et al., 2000; North, 1990). North (1990) defines institutions as “humanly devised constraints that

structure political, economic, and social interaction” (p.3). Although developing countries

are considered as important sources for future success, regarding their institutional

environment, they have lagged behind concerning various central areas such as infrastructure and labor (Hoskisson et al., 2000; Khanna et al., 2005; Rodrigues, 2012). Well-developed institutions are of great importance for economic success, while weak institutions

significantly hinder business operations (Porter & Stern, 2001). Properly designed institutions have the ability to reduce transaction costs and uncertainty; furthermore, it simplifies the execution of coordination processes (Alonso & Garcimartín, 2013). Institutional quality enhances productivity, whereas poor institutions frequently lead to unproductive performance (Dollar & Kraay, 2003). Luo (2003) suggests that uncertainty regarding the business climate in developing countries is further strengthened due to discontinuous administrative interface, unstable regulatory frameworks, and weak property right protection. Consequently,

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functioning of these markets (Khanna & Palepu, 2000). Hence, it is argued that it is challenging to operate under such conditions when striving for new product development, especially for Western MNEs (Ernst et al., 2015; Rodrigues, 2013; Peng, Wang & Jiang, 2008; Wright et al., 2005).

Given the crucial role of institutions in developing countries, it is vital for MNEs to recognize and understand the broader institutional environment in which their firms are embedded. Institutional quality appears to be of great importance in the progression of innovative output (Qu et al., 2017), as innovation concerns a resource intensive activity (Barasa et al., 2017). The presence of weak institutions threatens the effectiveness of factor markets, which increments transactions costs and aggravates information asymmetries. Therefore, it is believed that weak institutions negatively influence the possibility of

generating innovation (Meyer, Estrin, Bhaumik & Peng, 2009). Prior studies that investigated the quality of institutions across developing countries, generally define the phenomenon of weak institutions as institutional voids (Khanna et al., 2005; Rodrigues, 2012). Institutional voids refer to the diverse aspects concerning politics, labor, and products markets within developing countries (Rodrigues, 2013). It is argued that institutional voids have emerged in developing countries because economic growth is achieved much faster compared to the social and institutional structures, complicating to operate successfully in these markets

(Rodrigues, 2012). As extant literature emphasizes the importance of developing countries, the business

climate across developing countries is very ambiguous (Marquis & Raynard, 2015),

constraining MNEs in their innovative propensity (Barasa et al., 2017). Given the critical role of institutions concerning productivity and innovation (Porter & Stern, 2001), MNEs must understand if institutional voids have an impact on innovation performance. Only a few studies have investigated whether institutional voids negatively influence the execution of

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innovative activities (e.g. Barasa et al., 2017; Qu et al., 2017; Scheider, 2005). As these studies were focused on either one or a few countries, further research is needed that takes more developing countries into account, clarifying the effects of institutional voids in striving for the development of new products and services.

Previous studies illustrate that the movement of Western MNEs to developing countries is accompanied with additional difficulties, especially concerning the weak institutional environment across these countries. In the next chapter, the theoretical framework is discussed.

3. Theoretical Framework

The literature review underscores the importance of innovation allowing MNEs to economically grow and develop (Qu et al., 2017). In investigating innovation, three

theoretical explanations have been developed. Prior research emphasizes the impact of R&D, FDI, and international trade to enhance innovative performance (Feinberg & Majumdar, 2001; Salomon & Shaver, 2005; Zhang et al., 2007). However, many studies focused solely on one indicator exploring innovation, thereby limiting our understanding of how differences in innovation emerge (Wang & Kafouros, 2009). Furthermore, almost no literature has yet analyzed the concept of innovation in a developing country context (Ernst et al., 2015). The implications of prior research regarding innovation are limited due to the different conditions of innovation (Bradley, McMullen, Artz & Simiyu, 2012) and the quality of the institutional environment compared to developed countries. Furthermore, few studies analyzed how institutional quality, drawing on cross-country data, moderates innovation. However, given the fact that institutions appear to be of great importance concerning innovative activities (Barasa et al., 2017; Qu et al., 2017), MNEs must recognize the potential constraints that may

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arise from weak institutions when striving to enhance innovation performance (Khanna et al., 2005).

Altogether, applying this background and the relations between the addressed variables, this thesis will investigate whether R&D, FDI, and international trade improve innovation performance, drawing on the multidimensional framework by Wang and Kafouros (2009). Thereafter, an analysis of the moderating role of institutional voids is given,

providing additional knowledge of whether MNEs are hindered by poor institutional quality in developing countries when striving to innovate.

3.1 Innovation in Developing Countries

Given the unexplored phenomenon of innovation in a developing country context (Ernst et al., 2015), this research will specifically examine the nature of innovation across developing countries. Where Western MNEs previously turned to developing countries for the accessibility of natural resources, cheap labor, and inexpensive production opportunities (Garelli, 2008), these motivations are significantly changing characterized by shifts in globalization (Li & Kozhikode, 2009). MNEs from developed countries are recognizing the potential of developing countries to advance economic growth (Govindarajan & Ramamurti, 2011). As developing countries are economically stabilizing, poverty levels seem to diminish, emphasizing the fact that millions of people have transitioned into low or middle-income segments (Khanna & Palepu, 2000). Consequently, demand across developing countries is rising, which illustrates new opportunities for MNEs striving to grow their current businesses (London & Hart, 2004).

Even though demand in developing countries is rising (Atsmon et al., 2012), it appears that MNEs are struggling to successfully operate in a developing country context (Khanna et al., 2005). London and Hart (2004) stress that MNEs mainly focus on the top of

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the market, ignoring the potential stemming from the lower consumption classes, which diminishes the opportunity to realize business growth. Developed country MNEs prevail to assess strategies in which Western products are altered to local preferences; however, this hinders MNEs when exploiting the opportunities of the lower consumption classes

(Govindarajan & Ramamurti, 2011).

As scholars emphasize the importance of revising previous globalization strategies, it is increasingly becoming evident that MNEs must modify previous approaches in targeting developing countries (Govindarajan & Ramamurti, 2011). As of this, to actively participate in developing countries and capitalize the opportunities that arise from the consumption class of these countries, comprehensive information and innovative approaches are essential to compete in these markets (London & Hart, 2004).

3.2.1 Research & Development and Innovation

Even though the literature regarding the effect of R&D and innovation does not provide complete consensus, it is believed, based on the studies mentioned in the previous chapter, a true proposition can be made concerning the effect of R&D on innovation

performance. As illustrated by Mairesse and Mohnen (2005), MNEs preferably address R&D striving to advance innovation. This proposition is supported by Martín-de Castro, Delgado-Verde, Navas-López, and Cruz-Conàlez (2013), as the investment in R&D provides MNEs with an opportunity to boost their existing stock of knowledge, which, in turn, can be used to execute innovative activities. Furthermore, Hagedoorn and Cloodt (2003) exemplify that R&D supports MNEs in the development and introduction of new products into the

marketplace. Besides that, investments in R&D allow MNEs to reduce production costs and explore the pricing and products of competitors, from which their competitive position can be improved (Kafouros, 2008). Hence, R&D intensifies productivity, which supports the

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conversion of R&D input into innovative output (Penner-Hahn et al., 2005). Also, the indirect effects of R&D facilitate organizational learning, from which MNEs can advance the

knowledge regarding the external environment and foreign counterparts. As of this, given the illustrated positive relation between R&D and innovation, it is believed that R&D increases innovation performance. For that reason, the following is hypothesized:

H1: R&D has a positive effect on the innovation performance of MNEs in developing countries

This hypothesis leads to the statement that as the level of R&D increases, innovation performance will improve as well.

3.2.2 Foreign Direct Investments and Innovation

No thorough consensus has been described by the current literature on the relationship between FDI and innovation. Previous studies illustrate a positive relation between FDI and innovation, from which it is argued that FDI improves innovation performance. The

relationship between FDI and innovation is emphasized by Qu et al. (2017), as they identify FDI as a primary driver towards innovation performance. FDI can be regarded as a main channel through which knowledge and technology are spread. Cheung and Lin (2004) state that FDI may improve the innovative competence of firms through the movement of labor, information, and demonstration effects. Additionally, foreign investments generate spillover effects, reinforcing, for example, the diffusion of revolutionary technologies and expertise brought by foreign investors (Feinberg & Majumdar, 2001). As such, through learning-by-doing and learning-by-watching, additional knowledge can be acquired, which can be pertained internally to improve current innovation activities. The knowledge spillovers that derive from FDI, thus, provide MNEs with an opportunity to learn from the innovative efforts

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executed by external parties (Branstetter, 2006). As of this, FDI constitutes for indirect learning effects, advancing organizational learning (Scott-Kennel, 2007).

Hence, taken the above-illustrated studies into account, it is expected that FDI serves as a vital force enhancing innovation performance. As such, the second hypothesis is

therefore proposed as:

H2: FDI has a positive effect on the innovation performance of MNEs in developing countries

As the level of inward foreign investments increases, innovation performance will advance.

3.2.3 International Trade and Innovation

Concerning the third addressed driver of innovation, international trade, prior studies assess international trade as positively related to innovation performance. Previous research illustrates a clear view of what MNEs can expect from the effects of import and export on their innovation performance (Wang & Kafouros, 2009). Liu and Buck (2007) argue that import and export serve as adequate mechanisms through which innovation may advance, due to the indirect transfer of knowledge. Regarding export, MacGarvie (2006) illustrates that exporting permits MNEs to boost innovation, given the exposure to products and

technologies from foreign counterparts, analyzing their innovative efforts. Furthermore, export assists in acquiring different forms of knowledge, capturing new ideas, and information on consumer desires (Salomon & Shaver, 2005). Import, on the other hand, facilitates the exploration of advantages embedded in imported goods, which enables MNEs to improve their innovation performance by learning from foreign competitors (Kumar & Aggarwal, 2005). Given the exposure to intensified levels of competition through

international trade, this may encourage MNEs even more to advance innovation performance (Kokko, 1996). Accordingly, international trade allows for the enhancement of innovation

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performance, as international trade transcends both tangible and intangible assets, which contributes to the productivity and innovation potential of other countries (Liu & Buck, 2007). As such, the following hypotheses are developed:

H3a: Export has a positive effect on the innovation performance of MNEs in developing countries

H3b: Import has a positive effect on the innovation performance of MNEs in developing countries

Consequently, in case import and export increase, innovation performance will increase as well.

3.3 Moderating Role of Institutional Voids

As the relationships between the assessed drivers of innovation performance are hypothesized, it is now possible to address the bigger picture. The previous chapters of this thesis illustrate that MNEs are increasingly expanding their geographical scope, turning to developing countries to profit from their future economic growth (Ramamurti, 2012).

Nevertheless, it appears that MNEs are still hindered in the execution of the right strategies to innovate and compete in developing countries successfully (Atsmon et al., 2012; Brem & Wolfram, 2014; Khanna et al., 2005). Extant literature illustrates the differences between developing and developed countries (e.g. Wright et al., 2005). Especially the institutional context across developing countries seems to impede MNEs in undertaking effective action elaborating on innovation (Lu, Tsang & Peng, 2008). Although developing countries have realized fast economic growth in the past decades, with regard to their institutional

environment, these countries have lagged behind (Rodrigues, 2013).

Given the unexplored phenomenon of innovation across developing countries (Barasa et al., 2017, Ernst et al., 2015; Qu et al., 2017), this research aims to address this gap by

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assessing a composite measurement to clarify how variances in innovation performance are caused within developing countries. Furthermore, this study contains an extensive analysis of the institutional environment in which MNEs are entrenched to examine innovation

performance.

Most developing countries can be recognized by their lacking governance, indicating the presence of weak institutions across these countries (Gupta & Abed, 2002). According to Qu et al. (2017), amongst the many significant forces that drive innovation, institutions appear to be of great importance. Institutions concern various laws, regulations, property rights, and contracts, supporting the effectiveness and efficiency of innovative activities (Dunning & Lundan, 2008). As of this, in exploring innovation across developing countries, drawing on the institutional-based view, institutions should be centralized (Lu et al., 2008). The importance of institutions is further emphasized by the fact that MNEs may be interfered within the execution of innovative activities, relying on the institutional quality of countries (Barasa et al., 2017), reinforcing the necessity of institutions in addressing innovation (Qu et al., 2017). Institutions offer support in generating innovation by mediating regulations that determine innovation (Oyelaran-Oyeyinka, 2006). Altogether, the institutional quality of countries describes the soundness of the business climate and substantially determines the value that can be appropriated for the undertaken innovative activities (Barasa et al., 2017; Qu et al., 2017).

Given the critical role of institutions concerning innovation, this thesis aims to investigate the indirect effects of institutional voids by analyzing the financial market development and the level of business sophistication across developing countries.

According to Khanna et al. (2005), developing and developed countries are significantly different regarding the effectiveness of their financial market institutions. Developed countries are characterized by well-developed financial market institutions,

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referring to greater institutional quality. However, this is not the case within developing countries, as their countries are characterized by poor financial market refinement (Khanna et al., 2005). Different studies emphasize the importance of financial support to stimulate innovation performance (e.g. Becker, 2013). Even though developing countries have made severe improvements regarding their business climate, MNEs are still challenged in their innovative activity in these countries given the lacking access to financial resources (Alvarez & Barney, 2014; Burgess & Steenkamp, 2006). Becker (2013) illustrates that stable financial market institutions allow MNEs to execute and improve innovation performance. Innovation performance refers to a resource intensive activity, is often expensive, and requires financial investments (Barasa et al., 2017). As of this, stable financial market institutions are

imperative in sustaining innovative outputs. Given the fact that developing countries are characterized by weak financial market institutions, the following hypothesis is developed:

H4: Poor financial market development negatively moderates the relation between R&D, FDI, international trade, and innovation performance

This research also explores the perceived influence of the level of business sophistication within developing countries in stimulating innovation. Schwab and Sala-i-Martín (2016) define business sophistication as the quality of a nation’s overall business network and the endogenous business climate. In examining the soundness of business sophistication across developing countries, multiple factors come into play (Schwab et al., 2016). Firstly, the quality and quantity of local suppliers appear to be of vital importance (Chung & Kim, 2003). As MNEs cannot succeed in isolation in developing countries, the external environment in which they are embedded should be taken into account (North, 1990). MNEs collaborate with national third parties, such as the local clientele and suppliers, elaborating on innovation. This cooperation with external bodies contributes to MNEs’ internal stock of knowledge as these extrinsic sources provide further insights concerning

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domestic demand, facilitating the modification of existing products in line with customer needs (Arranz & Arroyabe, 2008). Due to that, the innovative potential of MNEs can be reinforced as these local, third parties supply and transfer additional assets and knowledge (Chung & Kim, 2003). Alternatively, MNEs may also benefit from the available local suppliers concerning cost advantages, through including these suppliers within existing business processes, facilitating cost efficiencies (Sobrero & Roberts, 2002). Furthermore, the value of local suppliers significantly determines the accuracy of transportation (Arranz & Arroyabe, 2008; Chung & Kim, 2003). Nevertheless, as developing countries mainly lack in the quality of the elements mentioned above, it is harder to draw on these additional

resources and to convert into innovative output (Allen & Cohen, 1996). Besides that,

developing countries vary in the quality of their distribution and production channels, product markets, and logistics, which hinders innovativeness (Khanna et al., 2005). Moreover,

business sophistication also concerns the capacity for cluster development across countries, as clusters play a fundamental role regarding economic development and competitiveness (Schwab et al., 2016). According to Paraušić, Cvijanović, Mihailović, and Veljković (2014), clusters stimulate in the creation of a favorable business climate, progressing productivity and innovation. In developing clusters, a country’s state of economic development appears to be crucial. However, developing countries have lagged behind in the quality of their business climate and stage of development, compared to an advanced context, which affects the opportunity for these clusters to develop efficiently (Paraušić et al., 2014). Developing countries are not sufficiently matured and fall short regarding supporting parties (e.g. infrastructure, administrative efficiency) (Khanna et al., 2005), which constrain clusters to develop fully (Paraušić et al., 2014).

Subsequently, the above arguments illustrate that the level of business sophistication is of value to innovative processes; the following hypothesis is therefore developed:

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H5: Poor business sophistication negatively moderates the relation between R&D, FDI, international trade, and innovation performance

Figure 1: Theoretical Framework

To summarize what is proposed in the hypotheses, this research identifies an effect as described in the theoretical framework outlined in figure 1. This structure and its assumptions follow the conceptual framework by Wang and Kafouros (2009) as it focuses on the effects of R&D, FDI, and international trade in determining innovation performance, across

developing countries. In addition, the institutional environment within developing countries is taken into account.

4. Data and Methodology

This chapter reviews the data that are used in this study by clarifying the methodology. Besides that, general remarks are made about the dataset, sources, and variables. This thesis uses a panel research design to measure the effects of R&D, FDI, and international trade on innovation performance, with institutional voids as the moderating variable. The method applied to test the expected relations is a regression analysis.

R&D FDI International Trade Innovation Performance Institutional Voids H2 H3ab H1 H4 H5 Financial Market Development Business Sophistication

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4.1 Sample and Data Collection

This research proposes to investigate the effects of R&D, FDI, and international trade on innovation performance within a developing country context. To test this relation, the overall sample population of this study is an all-country analysis based on various developing countries worldwide. As such, our understanding improves concerning the factors that

contribute to innovation performance in developing countries. In addition, this research aims to explore how institutional voids moderate this relationship, providing additional insights regarding the impact of poor institutional quality on innovation performance.

To gather the data on the all assessed variables, multiple databases have been used. For the collection of the dependent variable, innovation performance, data from the Global Innovation Index (GII) are used. In collaboration with Cornell University, INSEAD, and the World Intellectual Property Organization (WIPO) the GII is issued every year. The report is intended to capture the numerous features of innovation, drawing on cross-country data collected from 138 different countries worldwide. The GII is built based on two key pillars: (1) the Innovation Input Sub-Index, based on multiple elements of the national economy favoring innovation activities, and (2) the Innovation Output Sub-Index, measured on actual evidence concerning innovative output (Dutta, Lavin & Wunch-Vincent, 2016). Given the fact that this study is focused on innovation driven output, the latter will be used. For the independent variables, R&D expenditure and international trade, data from Euromonitor are used. Euromonitor is a global research market organization that is concentrated on providing strategy research. Based on the cross-country data Euromonitor provides, organizations have the opportunity to identify and develop growth strategies applicable in different nations. Euromonitor holds information on various industries, economies, countries, and consumers collected in 781 cities, 210 countries, and 27 industries (http://euromonitor.com). Data concerning inward foreign investments are retrieved from the World Bank. The World Bank

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gathers and converts large amounts of data from many countries worldwide. The data generated are centered on different economic models. Databases from the World Bank hold statistics and figures from over 200 countries across the world based on 1,200 indicators (http://data.worldbank.org). For the moderating variables, financial market development and business sophistication, data are used from the World Economic Forum Global

Competitiveness Index. The Global Competitiveness Index (GCI) is a report that is published each year by the World Economic Forum. The report contains data, which review the

competitive landscape of 138 different countries around the world, delivering worthy information concerning the level of productivity and growth of these countries. The index is made up of 112 different variables, based on 12 pillars of competitiveness. The majority of this data is collected from the World Executive Opinion Survey, which captures opinions from over 14,000 business leaders, based on multiple subjects (Schwab et al., 2016).

To obtain a representative sample of various developing countries, all were listed based on the availability of data concerning the variables addressed in this research. The developing countries discussed in this study were selected using the country classification developed by the United Nations (2017). The following sample criteria were established: Firstly, data on R&D expenditure, the level of inward FDI and international trade of the developing country must be obtainable. Secondly, in measuring the effects of institutional voids, data concerning the assessed institutional pillars in this research must be available per country. Thirdly, in identifying the influence of the independent variables on the dependent variable, data on innovation performance must be accessible for the applied developing countries. Lastly, data on all variables and for each country must be available from 2011 up to and including 2015.

In collecting data on all variables, data from 150 different countries were available and incorporated in an overall dataset. After that, in applying the above filtering, it became

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evident that 90 countries matched the sample selection. From those 90 countries, 51 countries could not be identified as developing, and thus, were excluded from the selection.

Consequently, the final dataset consists of 49 developing countries, with observations over a five-year period (2011, 2012, 2013, 2014, and 2015), resulting in 245 observations.

4.2 Variables

In the next section, the variables used in this research and the applied measures for each variable are explained (Table 1). To test the hypotheses, this research addresses existing measurements derived from the GII, the GCI, Euromonitor, and the World Bank.

4.2.1 Dependent Variable

The dependent variable in this research is innovation performance. Innovation performance is operationalized based on the Innovation Output Sub-Index, as mentioned in the GII. The GII explores the level of innovation output across countries elaborating on two pillars, namely: (1) knowledge and technology outputs, and (2) creative outputs. In measuring knowledge and industrial outputs, the GII captures those factors that contribute to countries’ innovative activity. As of this, the Innovation Output Sub-Index refers to in-country

knowledge creation, impact, and diffusion. Measurements include, for example, the amount of scientific and technological articles or patent applications. To evaluate the level of creative outputs per country, the GII analyzes the number of intangible assets, innovative goods and services, and the online creativity per economy. This is calculated, among others, by

trademarks and the export of creative goods. Countries are ranked based on a scale varying from one to 100 (Dutta et al., 2016), indicating that countries ranked with one are perceived as weak concerning to their level of innovation performance, whereas countries that score 100 are strong regarding innovation.

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4.2.2 Independent Variable

The independent variables of this study concern R&D, FDI, and international trade.

R&D expenditure. According to Hagedoorn and Cloodt (2003), the level of R&D spending of

organizations is an important indicator when analyzing the efforts organizations put into R&D investments. Therefore, this research deploys the level of R&D expenditure per country to measure R&D. As such, this study takes existing data from Euromonitor to calculate the overall level of R&D spending per country. Euromonitor refers to R&D’s spending as

investments performed throughout a particular period, executed within country boundaries or financed by foreign companies, excluding R&D expenses made in countries outside the home country (http://euromonitor.com).

Inward Foreign Investments. Inward FDI concerns the second independent variable. In

analyzing the degree of inward FDI, this research elaborates on the level of inward

investments made by foreign parties across developing countries (http://data.worldbank.org).

International trade. Chapter 2.2.1 exemplifies that international trade refers to the

movements of goods and services across national borders. This research measures both the effects of import and export across countries in determining innovation performance. International trade is be measured by using existing data from Euromonitor, capturing both the amounts of goods leaving and entering certain countries (http://euromonitor.com).

4.2.3 Moderating Variable

For the moderating variable, institutional voids, data were retrieved from the GCI. The moderating variables integrated into the framework include financial market

development and the level of business sophistication across. The applied institutional components are operationalized by using existing scales, which are developed by the GCI.

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Both scales vary from one to seven, illustrating that institutions that are ranked with one can be identified as weak, while a seven indicates a stronger institution.

The first institutional pillar refers to the level and quality of a nation’s financial sector and economic actions, defined as the financial market development. To calculate this

institutional component, data were taken from the GCI. The GCI measures the level of financial market development based on two indicators: (1) efficiency, and (2) trustworthiness and confidence of the financial market institutions. Concerning efficiency, the index

discloses, for example, the availability of financial services and quality of the local equity market. Also, to analyze the trustworthiness and confidence of the financial market sector, the index mentions, among others, the regulation of securities exchanges. In collecting the data for the financial indicators in capturing this institutional pillar, the GCI retrieves data from the World Bank, the World Economic Forum, and the IFC, which is depicted in an overall measurement (Schwab et al., 2016).

The second institutional indicator of this research concerns a country’s business sophistication. In defining business sophistication, the overall quality of business networks and the endogenous business climate across countries are captured. To measure business sophistication, this research collects data from the GCI. The GCI analyzes this institutional pillar based on different indicators, for example, the quality and quantity of local suppliers, the state of cluster development, and production process sophistication. The GCI aggregates each of these indicators into one overall measurement for business sophistication (Schwab et al., 2016).

4.2.3 Control Variable

The control variables used in this research are market size, the level of foreign presence, and educational quality, as these indicators are related to innovation performance.

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Market size. Market size is often used as a control variable given its effect on a

country’s overall productivity, permitting firms to exploit economies of scale easily. According to Porter and Stern (2001), changes concerning a country’s market size relate to alterations elaborating on innovative capacity. Consequently, this research controls for market size to improve the overall reliability of the study. In measuring market size, this research takes data from the GCI. The GCI calculates market size based on a scale varying from one tot seven. This scale implies that markets assessed with one are smaller regarding their size, whereas seven corresponds to a greater market size.

The level of foreign presence. The degree of competition is the second control

variable added in this research, due to its impact on innovation performance. Previous research investigated the relationship between foreign presence and innovation performance. These studies exemplify that countries with higher levels of competition favor local firms due to demonstration effects, spillover externalities, and organizational learning, from which innovation performance may be enhanced (Buckley, Clegg, Wang & Cross, 2002; Wang & Yu, 2006). Foreign presence is calculated by taking data from the GCI, which integrates data on domestic and overseas competition from the World Economic Forum, World Bank, and the IFC (International Finance Corporation) in an overall measurement. As such, this variable is measured by taking an existing scale regarding level of competition developed by the GCI, which ranks the level of competition on a scale from one to seven.

Education. The final control variable of this research regards a country’s overall level

of education. Prior studies argue that a country’s overall quality of education positively affects the innovation potential of that country, which illustrates the necessity of having well-educated employees elaborating on innovation (Barasa et al., 2017). For that reason, this study controls for the level of education, by taking data from the GCI. The GCI measures educational quality by gathering data from the World Execution Opinion Survey, in which

What factors drive innovation performance in a developing country context? : a panel research testing the influence of institutional voids on the relationship between R&D, FDI, and international trade in enhancing innov