Does investment in political connection matter for a firm’s radical and incremental innovation activities?

Does investment in political connection matter for a

firm’s radical and incremental innovation activities?

Evidence from Eastern Europe and Central Asia

By Geralda Wessels

s1870653

g.m.wessels@student.rug.nl

Date: June 15, 2015

University of Groningen Corvinus University of Budapest Faculty of Economics and Business DDM: International Economics and Business

ABSTRACT

This study is twofold and investigates the impact of political connection on radical and incremental innovation. Furthermore, it examines the interplay between bribes and political connection and its jointly effect on innovation. By focusing on 30 transition countries within the region of Eastern Europe and Central Asia. This study reveals that firm’s investment in political connection both in time and money increases the probability of radical innovation but has no significant impact on the probability of incremental innovation. Suggesting that firms should be cautious about the heterogeneity of political connection impact on particular types of innovation. Besides, findings reveal that investing in political connection increases the probability to bribe. And finally, findings of this paper suggest that bribes have a negative moderating effect on political connection thereby decreasing the probability to innovate radically.

1. INTRODUCTION

resource-based view of firms already suggested, heterogeneity of innovation is related to the differences in external factors such as business environment and internal factors such as size or age of the firm. According Markids & Geroski (2005) mostly small firms or start-ups develop radical innovations. Acemoğlu, Akcigit & Celik (2014)found that young innovative firms that are successful often grow fast and become large firms. Whereas, young start-ups that are not successful often exit the market. Girma, Gong & Gorg (2009) found foreign ownership and the integration of firms into a global supply chain as innovation drivers. According Golovko & Valentini (2011) exporting is seen as innovation driver, due to the spreading of fixed costs of innovation and higher competition levels when firms compete in international markets. Furthermore, when firms are participating in the international market they are likely to use foreign technology, which drives innovation (Fortwengel, 2011).

political connection and technology innovation outputs. Despite the scarcity of research on the influence of political connection on innovation and mostly based on Chinese firm samples, I will try to fill the gap in the literature on innovation management in economies of Eastern Europe and Central Asia. So far, nobody looked at the impact of political connection on neither radical nor incremental innovation.

The political literature recognizes political connection as rent-seeking activities where firms search for preferential treatment from governments. Whereas, bribing is seen as illegal activity political connection is seen as a legal activity. The phenomenon of political connection is more likely to be established in economies with weak institutional frameworks, because the dependence of political connection originates where politicians have almost no accountability (Desai & Olofgard, 2011). For this reason political strategies are developed by firms, indirectly this means gaining information, influence, resource access, lower taxation, lower uncertainty and lower transaction costs, which matters for the overall performance of firms (Shi & Zhu, 2014). These factors may also influence innovation decisions of firms, because it reduces uncertainty and finance obstacles as the literature in the field of finance already suggested that politically connected firms get more government protection (Faccio et al., 2006), take higher financial risks (Boubakri et al., 2013), have more access to financial resources (Claessens et al., 2008).

The area of interest is Eastern Europe and Central Asia. I use the 2012-2013 BEEPS survey data for 15.883 firms in 30 countries of this region. Focusing on these transition countries is interesting, because these countries provide a setting in which the countries almost started with similar political frameworks. Moreover, time-consuming bureaucracy characterizes this region and business permits are seen as important obstacles (Michelson, 2007).

innovation types, namely radical and incremental innovation, both need to be taken into account because the impact might differ so different policies should be shaped. The research questions are as following (1) Does investment in political connection increases the probability of radical and incremental innovation? (2) Does political connection increases the propensity to bribe? To investigate whether bribes and political connection are substitutes or complements. Finally, (3) is there a mutual effect of political connection and bribes on the probability of innovation? I intend to make several contributions. The first one is on innovation management literature. Second, this study allows the integrating of innovation literature and political science. Third, my framework shed some new lights on the debate on whether the value of political connection declines or increases after transition. As some studies suggest that the value declines with institutional development (Guthrie, 1999) and others argue a persisting value of political connection (Michelson, 2007).

2. LITERATURE REVIEW AND HYPOTHESES DEVELOPMENT

2.1 Innovation

innovation into the older concept of technical innovation such as process and product innovation. The same counts for the paradigm shift of main drivers of innovation such as R&D and technology. Innovation depends on internal and external factors. Innovative firms are sensitive to their environments. In countries where business constrains are less binding, firms innovate more (Boubakri et al., 2008). However, firm age, size, ownership structure and export status of firms have as well an impact on innovation. Furthermore, transition economies are developing and moving to the technological frontier. This means that the higher order radical innovation is going to be more presence in the region of transition countries (EBRD, 2014).

For this reason I argue that it is necessary to take two distinctions of innovation into account. However, the distinction between incremental and radical innovation is a matter of degree. According Leifer et al. (2000) radical innovation might lead to the following (1) it has an entirely new set of performance features (2) improvements in known performance of five till ten percent (3) at least 30 percent of reduction in cost. Radical innovations are able to transform existing markets or may create new markets. Though, there is an issue with the definitions developed so far, they are mostly only able to identify a radical innovation ex-post. Some studies developed criteria through which the issue of defining can be solved ex-ante. Skarzynski & Gibson (2008) argue that an innovation is seen as radical when it at least is characterized by one of the following requirements (1) it needs to have the power to change customer expectations and behaviors drastically (2) it needs to have the power to change the competitive advantage (3) it needs to have the power to change industries. Besides, radical innovations are higher order innovations and have a high uncertainty level.

different forms. For example, a product can be improved by improvements in product performances or lower costs through use of enhanced features or materials or technical systems.

Nowadays firms cannot rely only on incremental innovations. According Leifer et al. (2001) in the global economy as of today firms need to face and handle quick changes and only big firms can stay competitive in the short run by implementing incremental innovation. Only radical innovations can change the way of doing business and could lead to long-term economic growth. Furthermore, radical innovation might be a requirement for the survival of firms in the sense that radical innovation is a basis for future generations of products and services (McDermott & O’Connor, 2002).

2.2 Political connection

Political connection is seen as a firm’s capability to change and influence the rules in legislation and laws. Political connection is a kind of special form of lobbying which can been seen as a special form of corruption focused on legislative or rule making institutions, though this is seen as a legal activity (Houston et al., 2012). Many firms have developed different strategies to establish their relationship with government officials. To name a few of these political strategies it can be shaped as payments to government officials for campaigns, lobbying in favor for the firms or the cooption of politicians in the board of directors to name a few. Firms with a political connection gain favors that might cause for higher rates of profitability (Ritvala & Salmi, 2009). A growing number of studies are focusing on the benefits of political connection. However, firms can establish this connection at several levels. For example at higher levels this can occur due to the dependency of political parties on resources, such as money, votes or private gains (Welch & Wilkinson, 2004).

establish their political connection to increase the firm its profitability (Hadjikhani & Lee, 2006). Based on studies there are three main conclusions. The first one is that governments play a role in business. Second, having a political connection or not differs amongst firms, industries and countries. Third, political connection has firm performance consequences (Desai & Olofgard, 2011).

From the perspective of developing countries, political connection is particularly interesting after the fall of the Soviet Union. These countries had severe difficulties to tackle down corruption and handle interventions by governments whereas operating in an environment with high uncertainty legally and economically (Sukiassyan & Nugent, 2011). Moreover, in developing countries there are lots of bureaucratic restrictions upon business. These restrictions increase the power of government officials. For this reason political connection with government officials and politicians in developing countries might help to overcome obstacles (Hillman & Hitt, 1999).

From the perspective of Barney (1991) the resource-based view of the firm suggests that the competitive advantage of a firm comes from its valuable resources that are not easy to copy by its competitors. These resources may be tangible or intangible and may have been developed over a long period of time. A large share of a firm’s resources is relationship-based. So political connection is a relational asset, which means a private and firm level connection with government officials. Furthermore, when a firm establishes a political connection it will increase the chances of success. Politicians give firms privileges to those who are trying to connect (Boubakri et al., 2008).

2.3 The link between political connection and innovation

types in the literature; the first one is about the motivation of firms to get a connection, like searching for resources, shelter or for other reasons such as increasing personal status of managers (Agrawal & Knoeber, 2001; Shaffer 1995). As the resource-based literature pointed out having distinctive resources is an important tool for a firm to gain its competitive advantage, as not all firms are able to get a close connection (Hart & Dowell, 2011). Moreover, a distinctive resource in their view is a stable connection with the government that is helpful for firms to get critical resources required for innovation.

Second, another stream of literature is about the impact of political connection on the behavior or economic performance of firms. Most of the literature focused on this stream, with the impact of political connection on firm’s bank loans, lighter taxation and government contracts (Faccio 2006; Johnson & Mitton, 2003; Li et al., 2008). According Basile (2001) firm characteristics that reduces the costs of innovating increases the probability that innovation occurs. According Agrawal & Knoeber (2001) managers of firms who have political connection with government officials have higher sales to the government and have higher exports. Few studies focused on the impact of political connection on innovation of firms. However, the impact of political connection on innovation is similar to that of the economic performance of firms (Shi & Zhu, 2014).

(Peng, 1997). Peng & Heath (1996) argue that political connection might provide firms with access to resources in order to handle the uncertainties and challenges and thereby having a higher chance of successful strategic activities. Furthermore, they argue that political connection stabilize business in an uncertain environment by having members engage in reciprocal, preferential and supportive relationships. Firms differ in their abilities to manipulate the institution in their innovation process. Firms that are better at adapting to and influencing their institutional environments will be in the long-term more successful in innovation performances. Firms that make better use of these resources will reduce uncertainty, lower their institutional costs and create a more effective process of gathering resources (Ahlstrom et al., 2008).

2.4 Hypotheses

Firms are more likely to use their political connection if in the foreseeable future costs of seeking government or policy protection is lower than the costs of innovating. According Hillman & Hitt (1999) governments put economic regulations over firms such as, industry regulations, output restrictions, licenses, environmental regulations and labor regulations.

In the context of innovation, different levels of institutional uncertainties may arise, for this reason building a strong political connection is more beneficial when there is a higher need to reduce institutional uncertainties. Thus, whether time investment in political connection would benefit the firms’ probability of innovation depends on the type of the innovation. Therefore, I hypnotize that the optimal level of time investment by firm managers in establishing political connection with government officials may vary according to the nature of radical and incremental innovation.

safety clarification, taxation or environment impact inspections. It is especially important for innovation to protect itself from these types of regulatory requirements, for this reason firms could establish a connection with government officials and lobby for favorable decisions (Luo & Peng, 2000). On top of that it can also happen that an application for a permit can take a long period of time, months, years or it can even be rejected if the firm lacks a political connection. In a global competitive market a shorter time period of generating innovation ideas to actual releasing the product to the market does not only reduces costs but also increased the profits and may create first-mover advantages (Zhang et al., 2014). In case of developing countries it can be difficult to get financing in a short period of time, because financial institutions in developing countries are lacking in efficiency or there is a lack of property right enforcement, or lack of enough funding. Therefore, political connection may help a firm to gain loans or credit, subsidies, lighter taxation all from the government. Besides, political connection can also increase the confidence of firms (Zhang, 2006). Thus, all these features could enhance radical innovation.

The negative effect of political connection on radical innovation highlighted. Political connected firms may have less competitive pressure. Because political connected firms can have access to attractive projects or contracts or preferential help from governments so they face less pressure in the market, this may lead to inertia for these firms. There is a possibility that for this reason these firms lack the motivation for innovating and do not create the capability for innovation (Shi & Zhu, 2014). According Boubakri et al. (2008) political connection may enhance the government’s intervention in firms. These government interventions could also lead to an increase of firm’s costs, because having a close political connection is costs money and effort.

Therefore I hypothesize this as follows:

Hypothesis1: firm’s political connection with government officials will have a

positive yet decreasing effect on radical innovation.

In contrast, when a firm engages in incremental innovation the impact of time investment in building political connection is likely to differ. In case of incremental innovation a firm may for example upgrade an existing product or generating an ISO certification. The level of uncertainty is much less when a firm for example makes a radical change like in radical innovation. This type of innovation involves lower technological uncertainty and institutional or regulation uncertainty (Lavia, Stettner, & Tushman, 2010). The upgraded product/service or another activity as a result of incremental innovation may remain in the already existing regulatory approvals and frameworks. Besides, inspection by government officials should be less compared to radical innovation. Therefore, effort of firms to build a political connection could still be the case, but the net benefit is unlikely to increase proportionally (Ahlstrom et al., 2008). Nevertheless, time invested in maintaining and building a political connection may be unproductive or even wasteful. As the already mentioned arguments for the benefits of political connection on radical innovation the opposite is likely to be the case for incremental innovation.

downstream value chain activities, where time-consuming permits may not be necessarily or business constraints are lower (Ahlstrom et al., 2008). Fourth, firms should implement customer-oriented strategy for incremental innovation and strengthen their sales capability in order to succeed in incremental innovation. Here focusing on political connection rather than at customers might be a distracting activity, which means reducing time of managers for main drivers of incremental innovation (Atuahence-Gima, 2005). Thus, likely this results in lower probability to innovate incrementally. Therefore, I argue that time spent at political connection has a negative effect for the probability of incremental innovation, as this would reduce management time investment in internal operational activities such as sales that are critical for incremental innovation activities. Similar, incremental innovation may remain in the already existing regulatory approvals and this activity is less uncertain. Hence, time investment in building and maintaining political connection with government officials will decrease the probability of incremental innovation:

Hypothesis2: firm’s political connection with government officials will have a

negative effect on incremental innovation.

often receive bribes in exchange for example, prohibiting the entry of competitors. The definition of corruption that is shared by the literature is a transaction between private and public sector, through which collective resources ends up illegally into private hands of officials. According Amundsen (1999) corruption can also lead to misallocation of resources, besides it can also influence the decisions making process. The common problem for both political and corruption is the weak accountability and lower institutional quality. Faccio (2009) argues that when corruption is often used as a strategic tool, the acceptance of society of corruption increases, thus more people believe it is expected and anticipate on corruption. Especially, when corruption takes place at high levels this will continue to lower level officials, these people will follow the examples or demands from higher levels. Indicating a persistent and reinforcing effect of corruption. Moreover, political connection drives firms rent seeking activities, which will create opportunities for corruption (Shi & Zhu, 2014).

development of a country. This is important because it also indicates that the switch from corruption to political connection as a tool of influence. So they argue that firms in less developed countries use corruption as a method of influence. Whereas, firms in developed countries use lobbying as method of influence. Though, due to the presence of political connection also in less developed countries, recognized by recent research of political connection in emerging economies in China (Peng & Lu, 2000), Russia (Batjargal, 2003) and Ghana (Acquaah, 2007) I prefer the study of Damania et al. (2004). On top of this argument Ayyagari et al. (2010) argue that innovative firms are more expected to pay bribes compared to non-innovators. For this reason political connection and bribes are expected to be complements rather than substitutes. Therefore I hypothesize the probability of bribing as following:

Hypothesis 3: Political connection increases firms’ probability to bribe.

On the other hand when firms pursue both activities simultaneously it may also increase transaction costs, due to subjectivity of government officials, both uncertainty and opportunities for corruption increases the costs of firms (Cuervo-Vazurra & Dau, 2015). If both activities are carried out at the same time this means cost for both activities, for bribing lower government officials and having political connection and investing in building and maintaining political connection. As political connection can demand unofficial gifts or payments to higher government officials, a firm may also needs to pay bribes to lower government officials, when enforcement of laws need to be weaker. Nevertheless, political connection as already described is a result of a cost and benefit analysis. When the costs are too high as the result of both activities it may not be beneficial anymore in overcoming the obstacles for innovation and gaining approvals. Therefore, I expect the need for political connection to overcome the uncertainty of the environment to be less when a firm is already involved in bribe activities. Because bribes already take away some uncertainty related to overcome obstacles for innovation. Therefore, firms are less likely to build or maintain their political connection when the same obstacles also can be removed by using bribes. Especially, when assumed that bribes are used to trespass lower order regulations and political connection is more focused on ongoing connection or more focused in changing regulations or even laws, thus the method of political connection or the method of bribes may be preferred in different situations or innovation nature. For this reason I expect as the degree of bribes increase the need for political connection to reduce uncertainty or to overcome obstacles related to innovation to be lower, for two main reasons, namely first for reducing uncertainty and second, for cost and benefit analysis. Therefore:

Hypothesis4: Bribes will negatively moderate the relationship between political

3. METHODOLOGY

3.1 Data

In order to test the hypotheses, I use firm-level data from the latest Business Environment and Enterprise Performance Survey (BEEPS), which is a joint activity of the European Bank for Reconstruction and Development and the World Bank. This survey was conducted in 2012-2013. It investigates the extent to which government policies and regulations stimulate or hamper firms operations and investment in Central and Eastern Europe and the former Soviet Union. The BEEPS survey is performed in all countries in the mentioned region. This edition of the BEEPS survey includes detailed information about innovation and corruption activities, besides it provides information on firms features and covered 15,883 enterprises in 30 countries of Eastern Europe and Central Asia: Albania, Armenia, Azerbaijan, Belarus, Bosnia and Herzegovina, Bulgaria, Croatia, Czech Republic, Estonia, FYR Macedonia, Georgia, Hungary, Kazakhstan, Kosovo, Kyrgyz Republic, Latvia, Lithuania, Moldova, Mongolia, Montenegro, Poland, Romania, Russia, Serbia, Slovak Republic, Slovenia, Tajikistan, Turkey, Ukraine, and Uzbekistan.

3.2 Measures of main variables

improved product or service with the product or service already offered by this firm different from each other?” In terms of the improved product looks different from the existing product. For all questions “yes” answers generated a value of 1 and “no” equaled 0. The second measure is whether the improved product/services is more efficient or easier to use than the existing product/service. For all questions “yes” answers generated a value of 1 and “no” equaled 0. The third measure of incremental innovation is whether the improved

product/service has new functions or characteristics compared the existing product/service.

For all questions “yes” answers generated a value of 1 and “no” equaled 0.

Independent variables

Here one of the two measures of political connection is constructed, the other is highlighted in the robustness check section. The first measure of political connection is based on the responses to the question; “In a typical week over the last year what percentage of total senior management time was spent on dealing with requirements of government regulations?” It can be the case that senior managers meet government officials for mandatory reasons, but it can also be that senior managers meet government officials in several other situations, for example outside office hours. Nevertheless, some argue that spending time with government officials is a consequence of government regulations that are inefficient. Nonetheless, if this was true there will be little variation of the amount time spent among senior managers with government officials in regions with ineffective government regulations (Zhang et al., 2014). Besides, these authors argue that the above-mentioned measurement for political connection is a valid measure for building political connection. Therefore, I measure time investment in political connection as percentage of total senior management time spent on dealing with

government officials.

taxes, licenses, regulations and services. The item asked: “On average, what percentage of total annual sales, or estimated total annual value, do firms like this one pay in informal payments or gifts to public officials for this purpose?” Thus, I measure bribes as a percentage

of total annual sales paid as informal payment.

3.3 Control variables

In order to isolate confounding effects that might arise and to investigate the direct effect of political connection on radical and incremental innovation, several other drivers of innovation need to be controlled for.

Foreign ownership

According EBRD (2014) in the transition region more firms are foreign ownership than domestic owned and is foreign ownership is associated with a higher probability to innovate. I define majority foreign-owned when foreign investors hold a stake of 50 percent or more; this is to calculate the blocking minority. The numbers of new product or services introduced by foreign-owned firms is significantly higher than locally owned firms. This also counts for marketing and organizational innovation (Girma, Gong & Gorg, 2009). For this reason foreign ownership is coded as a dummy variable. I divide the sample firms in two different ownership types, the foreign-owned and domestic-owned firms. A domestic-owned firm has a value of 0 and 1 when it is majority foreign-owned for at least 50 percent.

Firm size

may have more resources to devote to innovation activities and more financial resources that may result into radical innovation of new products or services (Cohen & Klepper, 1996).

Firm age

Firm age is also included as control variable, as the number of years since the firm’s founding. Firm age is also an important factor for the innovation activities of firms. Older firms are expected to be less innovative than younger firms (Goedhuys, 2007). However, according Markids & Geroski (2005) mostly small firms or start-ups develop radical innovations. Firm age is measured by subtracting the year when the firm was established from the year of the last survey (2013).

Export status

I will also control for export status, Golovko & Valentini (2011) argue that export status of a firm will have a positive effect on firm innovation. Firms that export are more likely to innovate due to knowledge spillovers (Grossman & Helpman, 1991). However, the causality can be in two ways with innovative firms being also more likely to be exporters (Krugman, 1979). Furthermore, firms that export are able to spread their fixed costs of innovation so exporting in this way can stimulate innovation. The export status of a firm is a binary variable, export status, takes the value of 1 when a firm is considered as export firm and 0 otherwise. Measuring with a threshold of 10%.

Loan availability

accessibility to financing. Loan availability is a dummy variable and has a value of 0 if the firm has no credit line or loan, and has a value of 1 when a firm has a credit line or loan.

Fixed effects

Country and industry fixed effects are included in all models in order to account for possible idiosyncratic disparities between countries and industries.

3.4

Empirical strategy

Specification

Before I continue with the empirical strategy I performed a cleaning process described in table 1. It consists mainly in dropping those observations for which non-responses (-9) or refusals (-8) or in some cases (-7) does not apply; that have been observed in the dataset. The biggest problems are related to the percentage of sales as informal payments, corruption and political time spent. Besides, radical innovation and firm size cope with lots of missing observations. For this reason it is important to keep this in mind when interpreting the results.

Table 1: Description of the cleaning process

Cleaning criteria Non-response or refusal

Number of observations dropped in cleaning Sample before cleaning 15883

(-9) don’t know (-8) Refusal (-7) does not apply Radical innovation (product) 1074

Marketing innovation 15 Process innovation 16

Firm age 156 3

Incremental innovation (ISO) 54 4 1. Political connection (time) 1287 4

Corruption 869 9 Bribes 1179 342 Size 1074 28 748 Exporter 100 16 Foreign-owned 97 5 Finance 59 9 State-owned 2 Manager’s experience 170 7 9 Subsidies 47 5

Availability of skilled workers 285 5 External consultants 145

Radical innovation (new to market) 49 Radical innovation (new to world) 50

Incremental innovation (looks different) 20 1 15 Incremental innovation (efficiency) 21 37 Incremental innovation (New functions) 13 15

After having described the data and variables, the next section will proceed with the empirical strategy and empirical models that I will use to investigate the impact of political connection on radical and incremental innovation.

political connection. The BEEPS survey asked managers or owners of firms to tell whether their firms were confronted with corruption or asked the amount of their sales paid as bribes. Nevertheless, these questions have a sensitive nature. For this reason the responses can be biased.

The econometric model for radical innovation is as following:

RADICALINNOVFCS

=

β4politicalconF*bribesF+ α1FCFCS+ λC+ ηS +ε}

RADICALINNOV is a binary variable; if a firm introduced a new product or service in the last three years it takes a value of 1, otherwise 0. Politicalcon is in percentages of senior management time spent with government officials. FC includes the control variables of the firm for age, size, foreign ownership, exporter and financial access. λC and ηS are the fixed effect dummies controlling for industry sector and the country where the firm operates. F, means firm, s means sector, c means country and ε is the error term. Φ stands for cumulative standard normal distribution. Second, I also perform similar models with the robustness control variables; subsidies, manager’s experience, state-owned, availability of skilled workforce and use of external consultants. Third, similar models with other proxies of innovation as marketing and process innovation, politicalcon measured as political impact of informal gifts to parliamentarians and corruption measured as frequency of informal payments.

The second econometric model for incremental innovation is as following:

INCREMENTALINNOVFCS

=

Here similar models are performed, only this model tests for incremental innovation measured as whether the firm has upgraded their existing products or services. By looking at first, whether this upgraded product looks different compared to existing product. Second, whether the upgraded product or service is more efficient. Finally, whether the upgraded product or service has new functions. Moreover, in the robustness section incremental innovation is measured as obtaining an ISO 9000, 9002, 1400 certification.

Third, the propensity of bribing is modeled as following:

BRIBESFCS

=

Here the dependent variable is bribes in order to test hypothesis3.

Since probit models are non-linear, reporting robust standard errors is not a good approach to figure out potential heteroscedasticity. A non-graphical way to detect heteroskedasticiy is the Breusch-Pagan test. The null hypothesis is that residuals are homoskedastic. I cannot reject the null hypothesis at 95% and conclude that the residuals are homogeneous. Furthermore, I performed the Kernel density estimation, the lowess smooting and the local polynominal smoothing to test for an inverted U shape relationship between the innovation variables and political connection in a graphical way.

4. EMPIRICAL RESULTS

4.1 Descriptive statistics

products, which counts for incremental innovation. Furthermore, on average 15.7% of senior managers time is spent on political connection.

Table 2: Descriptive statistics

Variable Description Obs Mean Std. Dev

Radical innov New product or services introduced in the last 3 years (0/1)

9232 0.26 0.43

Incremental innov Holds an internationally-recognized quality certification (ISO 9000, 9002, 1400) (0/1)

9232 0.24 0.42

Marketing innov New marketing method introduced in the last 3 years (0/1)

7951 0.24 0.43

Process innov New methods of production or supply of products or services introduced in last 3 years (0/1)

7966 0.21 0.41

1. Political connection % Senior management’s time spent on dealing with regulations (0-100)

9232 15.77 20.56

Squared political connection % Senior management’s time spent on dealing with regulations (0-1000)

9232 671.71 1659.12

2. Political connection (impact) Private payments/gifts/other benefits to Parliamentarians –direct impact (1-5)

7982 1.40 0.85

Corruption Frequency of informal payments/gifts to get things done (1-6)

9232 1.86 1.17

Bribes % of total annual sales paid as informal payment/gift (0-100)

8820 0.82 4.01

Firm age Age (2013- start of operating) (1-162) 9232 15.52 11.32

Lnsize Logarithm of number of employees 9225 2.93 1.27

Foreign-owned Majority (50%) foreign ownership (0/1) 9232 0.04 0.20

Exporter Exporting firm (0/1) 9232 0.17 0.37

Loan availability Loan/credit from financial institutions (0/1) 9232 0.37 0.48

Subsidies Subsidies from national, regional or local governments or EU (0/1)

9232 0.08 0.28

State-owned Majority (50%) state ownership (0/1) 9232 0.01 0.10

Availability of skilled workforce % Of full-time employees holding a university degree

(0-100)

Manager’s experience Top manager’s number of years of experience working in this sector (1-70)

9232 17.39 10.21

External consultants Number of times an external consultant hired in the last 3 years (0-150)

7806 1.13 5.16

Radical innov (new to market) Product/service new to the firm its market (0/1)

1117 0.62 0.48

Radical innov (new to world) Product/service new to the world (0/1) 701 0.31 0.45

% sales new radical product innov

% of annual sales accounted for by new product/service

1572 27.75 25.00

Incremental innov (looks different)

Upgraded product looks different for the existing product (0/1)

1052 0.69 0.46

Incremental innov (efficiency) Upgraded product/service is more efficient/easier to use (0/1)

1066 0.68 0.46

Incremental innov (new functions)

Added new functions to existing product/service (0/1)

2116 0.70 0.45

4.2 Results

Table 3 in the appendix reports the correlations matrix of the main variables of interest. The correlations are in acceptable ranges.

the EBRD transition report of 2014. Firm age has a positive, instead of a negative relation with the propensity to innovate both for technical and non-technical innovation.

Model 2 investigates the effect of political connection on radical innovation measured as the introduction of a new product or service and time spent with government officials. Political connection is positive and significant at 5% level.

Model 3 tests hypothesis 1, a firm’s political connection will have a positive yet decreasing effect on radical innovation. In order to investigate this inverted U shape relation I generated a squared political connection variable, as the results of model 3 report, this variable is negative but not significant. Though, the political connection remains positive and significant in the same range of significance. Thereby not supporting my first hypothesis. Model 4 tests hypothesis 3, where political connection is expected to increase firm’s probability to bribe. Political connection has a positive relation and is significant at the 1% level. Confirming hypothesis 3, so having a political connection leads to a higher probability to bribe. This result is in line with the Damania et al. (2004) study, in which bribes and political connection are seen as complements of each other rather than substitutes. Model 5 investigates the impact of bribes on radical innovation, paying bribes is positive correlated with radical innovation and significant at 1% level, thus increasing the

probability of radical innovation.

Table 4: Results of probit models estimating for radical (product/service) innovation

Variables

Dependent variable: Radical (product/service) innovation Model (1) Model (2) Model (3) Model (4)

Bribes Model (5) Model (6) Political connection 0.0018** (0.0007) 0.0045** (0.0020) 0.004*** (0.0008) 0.0027*** (0.0007) Political connection squared -0.0000 (0.0000) Bribes % sales 0.0108*** (0.0035) 0.0222*** (0.0053) Political connection* Bribes -0.0004** (0.0001) Firm age 0.0027** (0.0014) 0.0027** (0.0014) 0.0027** (0.0014) -0.0017 (0.0018) 0.0027** (0.0014) 0.0027* (0.0014) Lnsize 0.0601*** (0.0133) 0.0597*** (0.0133) 0.0590*** (0.0133) -0.0673** (0.0179) 0.0627*** (0.0136) 0.0633*** (0.0136) Foreign ownership 0.1689** (0.0694) 0.1698** (0.0694) 0.1699** (0.0663) -0.0292 (0.0882) 0.1556** (0.0716) 0.1611** (0.0717) Loan/ access finance 0.2489***

(0.0324) 0.2479*** (0.0300) 0.2462*** (0.0324) 0.0668 (0.0421) 0.2498*** (0.0331) 0.2318*** (0.0307) Firm exporter 0.2774*** (0.0435) 0.2776*** (0.0435) 0.2767*** (0.0436) 0.1333** (0.05866) 0.2652*** (0.0445) 0.2645*** (0.0332) Constant -1.2795*** (0.1643) -1.2986*** (0.1648) -1.3043*** (0.1651) -1.2685*** (0.1528) -1.2910*** (0.1699) -1.3153*** (0.1706)

Industry fixed effects Yes Yes Yes Yes Yes Yes

Country fixed effects Yes Yes Yes Yes Yes Yes

N 9225 9225 9225 8793 8814 8814

LR Chi square 1237.94 1234.73 1245.98 687.25 1193.21 1208.43

Prob > chi2 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000

Significance level at 90% level * significance at 95%level ** significance at 99% level***

In table 5 the same probit models were used to test for the relationship between political connection and the probability of incremental innovation. Model 7 reports the results of the probit regression with all control variables. All the control variables are not significant except firm size. Firm size has a negative coefficient and is significant at a 10% level. Model 8 tests hypothesis 2 where political connection and incremental innovation proxied by whether the product looks different compared to the existing one and political time spent is expected to have a negative effect on the probability of incremental innovation. Though, the results of model 8 report a negative but not significant impact of political connection on incremental innovation. Thus, not supporting hypothesis 2. Model 9 tests for the impact of bribes on the probability of incremental innovation, showing a positive but not significant result. For this reason it is not surprisingly that model 10 shows an insignificant interaction coefficient of political connection and bribes, thus for incremental innovation hypothesis 4 does not count.

Table 5: Results of probit models estimating for incremental (upgraded product) innovation with fixed effects

Variables

Dependent variable: incremental (upgraded) innovation

Model (7) Model (8) Model (9) Model (10) Model (11) More efficient Model (12) New added functions Political connection -0.0006 (0.0021) -0.0019 (0.0022) 0.0029 (0.0102) -0.0023 (0.0015)   Bribes % sales 0.0173 (0.0151) 0.0034 (0.0192)   Political connection * Bribes 0.0010 (0.0009)   Firm age -0.0028 (0.002) -0.0028 (0.0029) -0.0024 (0.0031) -0.0024 (0.0030) 0.0016 (0.0052) 0.0000 (0.0025)   Lnsize 0.0646* (0.0366) 0.0637* (0.0367) 0.0740** (0.0375) 0.0721* (0.0375) 0.0071 (0.0422) 0.0172 (0.0265)   Foreign ownership 0.0379 (0.1763) 0.0383 (0.1763) 0.0698 (0.1856) 0.0718 (0.1860) 0.5361* (0.2230) -0.0223 (0.1210)   Loan/ access finance 0.0407

(0.0919) 0.0415 (0.0919) 0.0309 (0.0941) 0.0299 (0.0942) -0.1287 (0.0986) -0.1088* (0.0647)   Firm exporter 0.0144 (0.0144) 0.0137 (0.1051) -0.0074 (0.1075) -0.0068 (0.1075) 0.1787 (0.1411) -0.0218 (0.0787)   Constant -1.0111 (0.6500) -0.9897 (0.6524) -1.0558 (0.6532) -1.011 (0.6553) -0.5972 (0.9050) 0.4058 (0.5228)  

Industry fixed effects Yes Yes Yes Yes Yes Yes  

Country fixed effects Yes Yes Yes Yes Yes Yes  

N 1063 1063 1018 1018 998 2092  

LR Chi square 94.76 95.07 97.08 98.94 117.98 124.93  

Prob > chi2 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000  

4.3 Robustness checks

In this section I include additional control variables related to firm innovation. Besides, I also use other proxies to measure the main variables of interest. Again all the control variables are collected from the BEEPS 2012-2013 dataset.

4.3.1 Additional controls

Table 6 in the appendix reports the additional controls. The coefficient of political connection remains positive in the same range of significance level in all the additional control variable probit regressions.

The first additional control variable I included is subsidies, which are expected to lower the costs of innovation for the firms and higher the chance to engage in innovation (Habiyaremye & Reymond, 2013). For subsidies the item asked was: “Over the last three years received the firm subsidies from the national, regional, local governments or European Union?” The variable is coded as 1 if the firm received subsidies, otherwise 0. Model 13 confirms the previous claim; subsidies are positive and significant at 1% level. Political connection remains significant in the same range of significance.

The second additional control variable is state ownership. According EBRD (2014) firms that are majority owned by the state are less likely to innovate compared to locally private firms or foreign-owned firms. Managers in state-owned firms have lower intentions for innovation and to lower intentions to enhance efficiency. Moreover, these firms have the possibility to be bailed out when the firm its performances are bad or finances are poor.

State-owned firms are coded as 1 when the firm has a majority of state ownership with a threshold

of 50% and is coded 0 otherwise. In model 14 a state-owned firm indeed has a negative coefficient, though not significant.

driver of innovation at both national level and at firm level (Stern, 2002). According Sorescu, Chandy & Prabha (2007) differences between firms in attracting and keeping talented persons might be another feature that explains the differences in innovation output and the value of the innovation. According Habiyaremye & Remond (2013) high skilled labor is more creative and efficient and could be an indicator for a firm its ability to innovate. Availability of skilled

workforce is measured as the percentage of full-time employees holding a university degree.

Model 15 reports that availability of skilled workforce is positive and significant at 1% level, thus increasing the probability to innovate. Political connection remains significant in the same range of significance.

Fourth, Managerial experience is expected to enhance innovation. Experience of managers includes technological, organizational, managerial skills and knowledge (Weterings & Koster, 2007). Knowledge about how to innovate requires knowledge and expertise about technology and markets. Knowledge that increases with experience is helpful to understand and predict future innovation opportunities. Manager’s experience is measured by the answer to the question “How many years of experience has the top manger working in the sector?” Model 16 reports a positive and 1% significant coefficient of managerial experience, thus increasing the probability to innovate.

Fifth, Model 17 reports a recent claimed influential factor on innovation, the use of external consultants. According EBRD transition report 2014, consultants provide external knowledge and information which increases innovation potential. The item asked for External

consultants is: “In the last three years, how many times has this firm hired an external

consultant?” Model 17 reports a positive and significant at 1% level coefficient of external consultants, thus the use of external consultants increases the probability to innovate.  Thereby,   political connection remains significant in the same range of significance.

connection remains significant in the same range of significance. Thus, political connection remains in all models significant in the same range of significance, at 5% level.

4.3.2 Different proxies of main variables

For robustness I also include other proxies of both radical and incremental innovation, political connection and bribes. Table 7 in the appendix reports different proxies of innovation.

The first robustness measurement of innovation is the additional measurement of process innovation. Process innovation equals one when a firm has introduced a new method for production or supply of products or services in the last three years. Model 20 reports a positive and significant at 1% coefficient of political connection. Model 21 reports in contrast to my previous findings of hypothesis 1, an inverted U shape relation between political connection and innovation. The coefficient of the squared political connection variable is negative and significant at 1% level and the coefficient of political connection variable is as well significant at 1% level but positive. Thus, process innovation supports hypothesis 1.

and non-technological aspects of innovation are in line. Marketing innovation equals one when in the last three years a firm introduced a new marketing method. Model 22 reports a positive and significant at 1% coefficient of political connection. Model 23 also reports an inverted U shape relation between political connection and marketing innovation. The coefficient of the squared political connection variable is negative and significant at 1% level and the coefficient of political connection variable is as well significant at 1% level but positive, thus both process and marketing innovation confirms my hypothesis 1.

innovation, thus increasing the probability of incremental innovation. Model 25 tests hypothesis 2 where political connection and incremental and political time spent is expected to have a negative effect on the probability of incremental innovation. Though, the results of model 25 report a positive but not significant impact of political connection on incremental (ISO) innovation. Thus, again not supporting hypothesis 2. Model 26 tests the impact of bribes on the probability of incremental (ISO) innovation, showing a negative and not significant result. For this reason it is not surprisingly that model 27 shows a negative and not significant interaction coefficient of political connection and bribes, thus for incremental innovation hypothesis 4 does not count. This is consistent with the findings of the other measurements of incremental innovation.

In table 9 other proxies of the main variables of interest are estimated. The second measurement of political connection is measured as, “To what extent private payments/gifts/other benefits to parliamentarians had a direct impact?” Firms make unofficial

payments/gifts/private payments or other benefits to public officials/ parliamentarians to gain

Model 30 reports the probability to bribe now proxied as the frequency at which

informal payments are perceived to be a common behavior. The item asked was: “Is it

common for firms to have pay some irregular additional payments or gifts to get things done with regard to customs, taxes, licenses, regulations or services?” The model is in accordance with my previous findings of model 4, the test for hypothesis 3. The coefficients of political connection remain positive and significant at 1%. Finally, model 31 and model 32 confirm my previous results of the moderating effect of bribes on political connection and radical innovation and the not significant result on incremental innovation.

Finally, table 10 estimates the effect of radical innovation measured as percentage of sales of the new product. For this estimation a tobit model is used, the results confirm my previous findings on radical innovation. Moreover, in model 34, 35 and 36 different forms of radical innovation are estimated. Political connection is expected to have a stronger impact on higher order radical innovation. In contrary, as the findings suggest political connection increases the probability of radical innovation only when the radical innovation is new to the firm, as model 34 reports. In model 35 where radical innovation is new to the firm’s market and in model 36 when the radical innovation is new to the world, political connection is not significant anymore. Whereas, the estimation of new to the world and political connection the coefficient turns from positive to negative. Indicating that political connection is not significant for the most radical forms of innovation, such as new to the market and new to the firm.

4.4 Discussion

unpredictable results testing for hypothesis 1 and 2 can be found in the attempt to reduce uncertainty of the institutional context. I expected an inverted U shape relation of political connection and radical innovation; but my results present a positive and significant relation of both measures of political connection; time and money investment in political connection with the probability of radical innovation. So, for radical innovation there is a significant need to reduce uncertainty at all times. This may also be the result of the needed import licenses; often firms are dependent on imported inputs for their product innovation and technologies. This can be one argument to explain the linear relationship. According EBRD transition report (2014) customs and trade regulations are seen as an important obstacle for firms who innovate or wanted to release new products into the market. So firms may try to overcome this obstacle by investing in political connection. Moreover, according to Ayyagari et al. (2010) if a firm wants to introduce a new product on the market the firm needs to spent time with government officials, especially in environments that are characterized by time vague regulations, procedures and time-consuming bureaucracy.

Furthermore, I expected a negative relation of political connection and incremental innovation, but my results here are not significant. Suggesting that incremental innovation stays in the existing regulatory approvals so political connection does not have a significant impact on the probability of incremental innovation. This is true for all the different types of incremental innovation, such as incremental innovation in the form of adding new functions, making the product or service more efficient or changing the appearance of the product. Nonetheless they vary with positive and negative coefficients.

carried out inside the firm such as process innovation, firms face fewer obstacles of permits. So investment in political connection may only beneficial for safety permits and such, wherefore less time and effort is needed for obtaining these types of permits and firms may face less obstacles and risk. For marketing innovation these results suggests that political connection increases the probability of marketing innovation as well till a certain point and afterwards decreasing the probability of marketing innovation. This pattern is in line with the already above mentioned uncertainty reduction, marketing innovation may be a less risky innovation type compared to product innovation. So political connection can provide consumer or market insights and information gained from government officials. However, when too much is invested in political connection this leads to distraction and this could reduce management time investment in internal operational activities such as sales and marketing. Besides, little or no permits are needed for this type of innovation, because marketing touches upon mostly intangible resources. This may explain a positive yet decreasing relation of political connection and marketing innovation.

As my findings report, investment in political connection increases the probability to bribe, though firms need to be careful when they pay bribes and invest in political connection simultaneously. My results confirm that bribes have a negative moderating effect on political connection and decreasing the probability of radical innovation. This may simply be the consequence of a cost and benefit analysis, when both activities are carried out at the same time this may be too expensive. Or it generates a kind of willing to bribe reputation, which will decrease the effect of political connection. Or political connection and bribes can have overlapping features and consequences. Nonetheless, as expected this claim does not hold for incremental innovation, but this seems logically due to the insignificant effect of both bribes and political connection on incremental innovation.

Finally, I expected that higher order radical innovation would have a stronger relationship with political connection. As political innovation increased the probability of radical innovation, however this is not the case in the robustness check round. Only for the type of radical innovation that is new to the firm, political connection increases the probability of radical innovation. Political innovation is not significant anymore for the more radical forms of innovation such as radical innovation that are new to the market or new to the world. So this is not reinforcing my assumptions. One reason could be that I used a different subsample for these variables with lots of missing values. Another reason could be that these types of radical innovation are so drastic, that firms try to connect with governments outside this region. Besides the number of these types of radical innovation is very low in this region.

5. CONCLUSION

competitive advantage to increase the success of firms (Sawhney et al., 2006). The literature already underlined several important driving forces of innovation such as firm and environmental features. In contrary, this paper aught to fill the gap of innovation literature and strategic management literature by looking at a newly recognized intangible driving force of innovation, namely political connection. Governments have power over valuable and resources and more firms are trying to establish close connections with governments for resources and shelter (Dickson, 2007). This paper is based on developing markets with lower institutional quality in 30 transition countries. Findings of this paper show when firms invest in political connection they increase the probability of radical innovation. However, this is only true for radical innovation that is new to the firm and not new to the market or new to the world. Another kind of relationship is found between political connection and marketing and process innovation. Here, political connection has a positive yet decreasing effect on the probability of process and marketing innovation. Furthermore, political connection increases the probability to bribe. However, when a firm is investing in a political connection, bribing has a negative moderating effect on the effect of political connection on radical innovation. On the other hand, the findings reveal that there is no evidence of the impact of political connection on incremental innovation. Besides I find results about the interplay between bribes and political connection. In other words investment of political connection matters for some types of radical innovation but not for incremental innovation.

5.1 Implications

resources. Especially in times of economic crisis, CEO’s and managers are searching for new competitive resources. On top of that, when a firm has a political connection it increases the probability to bribe as well, which will harm the enforcement of laws and regulations. Furthermore, governments should be aware that as the results show, even after the transition and a more developed institutional framework of today compared to shortly after the transition, political connection has a persisting value, thereby supporting the stream of literature of (Michelson, 2007).

5.2 Limitations and future research

marketing innovation is seen as an increasingly important innovation type, especially in times of economic slow down. Concerning the measurement of political connection it would be interesting to analyze the direct effect of political connection, when it is possible to collect data about the cooptation of former politicians as members of the board of directors, this could give some new and stronger insights for the region of Eastern Europe and Central Asia. For example, this type of information is already available in some Asian countries. Furthermore, future research could devote attention to whether political connection is more effective in a particular industry or service sector. So these and other areas of research can be pursued to continue advancing the theory of political connection advantages on innovation pursued in this paper.

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