Effect of Small Firm Patents on Industry Growth

The Effect of Small Firm Patents on Industry Growth

David VossECON 400, Senior Seminar

Mon. 4:00-6:45Professor Walker

April 13, 20124

The Effect of Small Firm Patents on Industry Growth

I. Introduction

One of the most common perceptions of innovation is that small, entrepreneurial firms

are the entities that are pushing technology and advancing their industries as a whole. This

enhances the perception that the large, incumbent firms are only developing minor, incremental

changes with the purpose of slowly and steadily reinforcing their control on the market. The

majority of the expenditures on R&D that is carried out today are not by the small, AlO0entrepreneurial firms, but by a tiny number of very large companies. However, these

revolutionary breakthroughs are continuing to come from predominantly entrepreneurial

enterprises with large firms providing incremental improvements that add to major contributions

in their respective industries.

The number of major technical innovations that have been introduced by small and newly

created firms over the past 150 years is staggering, many of which play a direct role in our daily

lives. To list just a few: the incandescent lamp, alternating electric current, radio telegraph and

telephony, the dial telephone, the synchronous orbit communications satellite, the turbojet

engine, the sound motion picture, self-developing photography, and the electric calculator. One

can even offer the plausible conjecture that most revolutionary new ideas have been, and are

likely to continue to be, provided preponderantly by independent innovators (Baumol, 2004).

These entrepreneurial innovations have driven industries for years. The data I have

collected for this paper is in response to the previous statement on independent inventors worth

to an industry, and I will attempt to find the positive correlation between industry growth and

1There is also a good deal of R&D activity in universities and government laboratories. Clearly. this is not

research conducted by business, but much of it is different from the work of the independent innovator underdiscussion. For example, much of the activity of the independent innovator is conducted in pursuit of wealth, and itconsists primarily of applied rather than basic research. (Baumol, 2002)

1

whether or not it is indeed driven by entrepreneurial innovation across the 31 industries and sub-

industries where data was collected.

The notion that entrepreneurship drives growth is not a new idea. There is even a term

known as the incumbents curse which implies that if large, incumbent firms stick to the adage

of slow, minimal growth in order to keep from cannibalizing their own product, they will

eventually fall and give way to the newer, smaller, and more innovative firms (Chandy and

Tellis, 2000). Eastman Kodak is a perfect example of how a company can fall victim to this

curse.

When was the last time you heard the phrase a Kodak moment? Up until about 1995,

Kodak had been the commercial giant in photography. Since 1887, they were the industry

standard and the driving force behind film and camera technology with one incredible innovation

after another. However, failing to keep pace with the digital revolution which has taken place

over the past 20 years that has captured nearly full control of the photography market, Kodak

hardly stood a chance against current day industry giants like Canon, Nikon, and Sony (these

three firms collectively controlled about 50% of the market in 2010, while Kodak held on with

7.4%, respectively). By failing to adapt to a changing environment, Kodak has fallen victim to

the aforementioned incumbents curse. On January 19, 2012, Kodak filed for Chapter 11

bankruptcy.

II. Literature Review

Previous studies have shown that the amount of innovation in a given industry that is

created by small firms and entrepreneurs is just as likely to cause economic growth as innovation

provided by large firms. This could somewhat lopsided information could be due to skewed

statistics because of inter-firm cooperation occurring with the smaller firms simply selling their

2

ideas or collaborating with larger firms. By large and small firms combining their ideas, larger

firms will generally be able to further the technological development, thus receiving the credit

for industry growth due to their innovations.

Rothaermel (2001) examines how inter-firm cooperation between incumbents and

entrepreneurs allows the incumbent firms to adapt to technological change at a faster rate by

exploiting their own existing assets instead of focusing strictly on R&D. He finds that

incumbents who have a greater focus on networking with small firms and entrepreneurs rather

than exploring new technology are more successful and able to adapt faster. This collaboration

has the ability to enhance a large firms success with innovative change while still keeping small

firms an integral part of their industry.

Rothaermel isnt alone in his analysis. While large and small firms may not always work

in conjunction with each other, large firms still have much to benefit from their smaller

counterparts. In a paper by William Baumol (2002), he refers to entrepreneurs as Davids and

the industry incumbents as Goliaths. Baumol finds there is a rather predictable tendency

towards specialization: the entrepreneurs providing the mere heterodox, breakthrough

innovations, and the R&D establishments of the larger firms creating the enhancements to those

breakthroughs that contribute considerably to their usefulness. So, as opposed to Rothaermels

conclusion that the collaboration taking place between large and small firms helps large firms

succeed, Baumoi has deduced that by large firms simply watching how small firms innovate and

then tweaking the technology to their advantage, the Goliaths, through their wealth of resources

will be able to prosper and further the innovation spearheaded by the entrepreneurs which leads

to economic growth in their industry.

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At the end of Section I, I implied that the incumbents curse was a natural phenomenon

that a firm could do its best to avoid, but may well wind up falling victim to in the end. Consider

the paper by Chandy and Tellis (2000). Their explanation of the curse plainly suggests that

incumbents are much less likely than non-incumbents to introduce radical innovations2.They

define incumbency as a firm that manufactured and sold products belonging to the product

generation that preceded the radical product innovation. From this definition, they find that of the

64 innovations in their sample size, 53% are from non-incumbents, whereas the remaining 47%

come from incumbents. With the differences between the proportions being so insignificant,

through their analysis Chandy and Tellis imply that incumbents may be as likely to radically

innovate as non-incumbents, debunking the incumbents curse.

I mentioned in the opening of this section that the industry growth statistics may be

skewed in favor of large firm innovation, due to their ability to take advantage of smaller firms

ideas and make them their own, either through a buyout or by enhancing newly developed

technology through established R&D. However, when an incumbent firm takes the initiative to

innovate without outsider influence, we can see the innovative efficiency shift back to small

firms. Russel Knight (1989) compared 236 Canadian entrepreneurs, 124 being independent and

the remaining 112 coming from corporations (from now on referred to as intrapreneurs), all

involved in high-tech industries. Knight discovered that while intrapreneurs have more resources

at their disposal, they also have more than just development of a product to deal with. Some of

these hindrances may involve trying to convince management within the corporation to believe

in the product currently on the drawing board, obtaining finding to farther their project, or

2 A radical product innovation is a new product that incorporates a substantially different core technologyand provides substantially higher customer benefits (Chandy and Tellis 1998). A radical product innovator is thefirm that first commercializes a radical product innovation.

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providing incentives and rewards for team members. These are all problems that can plague

development in large firms. Small firms still have to jump over several hurdles throughout their

innovation process, but their problems generally arise after their product is developed, not prior

to. Knight found that while entrepreneurs may not have to deal with all of the red tape that is

involved with corporate structure, they often struggle with post-development problems such as

marketing and management. While the majority of the entrepreneurs where technically trained,

the lack of general management training and experience caused them to list marketing as the

most difficult problem when it came to launching their new product.

Granted, the innovations provided by the entrepreneurs were all new product designs, in

comparison to the new products designed by the intrapreneurs which were generally a new take

on old systems or processes. Since the intrapreneurs werent necessarily inventing a product, but

more so tweaking and enhancing an existing product, they are able to take advantage of the

market for the product already being established and marketing costs are less than if they had

developed a new product. But even with this marketing advantage, Knight found these large

firms tend to suffer from a lack of entrepreneurial talent within the company. The obstacles in

the paths of both the entrepreneurs and intrapreneurs studied lead to a high recommendation

between the large and small firms to form cooperative agreements of partnerships with each

other to solve these difficulties.

III. Methodology

Data

From the Bureau of Economic Analysis, I collected data from 31 industries, some being

complete industries, such as electrical or health, and some very specific sub-industries, ranging

from resins and polymers to cranes and hoisting equipment. The BEA, specifically bea.gov, is a

S

great and very likely the most in-depth source available where I would be able to compare

numerous industries and their growth patterns over several years. I have only collected data from

the 10 year span of 1998-2007, largely due to the 1997 change over in industry codes from the

Standard Industrial Classification (SIC) system to the North American Industry Classification

System (NAICS). For fear of contaminating my results with incorrect cross-referencing of

industries from SIC to NAJCS, I decided to use the NAICS codes only, thus I restricted myself to

a 10 year window. These codes are used for the collection, tabulation, presentation, and analysis

of statistical data describing the U.S. economy. The NAICS was developed in conjunction with

Mexicos Instituto Nacional de Estadistica Geographia and Statistics Canada in order to create a

high level of comparability in business statistics among North American companies. For my

paper, I will only be focusing on American industries. NAICS codes range from two to six digits;

the more digits in the code, the more specialized the industry. For example, agriculture,

forestry, fishing and hunting has the 2 digit code 11. Venture deeper into this industry and

youll find the food and crops grown under cover industry with the 5 digit code 11141.

Continue down one level further and you find mushroom production with the 6 digit code

J 111411 Through the NAICS, you are able find industries and their very specific sub-industries

with relative ease.

Jam using four variables to determine different aspects of growth across 31 industries for

the 10 year period between 1998 and 2007. By collecting data for Value Added Growth

(ValAdGr98toO7), Gross Output Growth (GrossOutGr98toO7), Full-Time Equivalent Employee

Growth (FTEEmpGr98toO7), and the percent of patents owned by small firms (PctSmall), I am

testing to see whether or not the specified areas of growth in these 31 industries are positively

tied to the percentage of patents produced by small firms in the 10 year period observed./

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I have defined a small firm as a firm with less than 500 employees. I will run three 9different ordinary least squares (OLS) regressions, all using the percent of patents produced by

small firms as the independent variable. The regressions are as follows: -

Value Adjusted Growth ,8o 1- fii(% ofsmallJIrms with patents,) + c (1)

Gross Output Growth ,Bo + fli(% ofsmalljirms with patents) + et (2)

Full- Time Equiva/en! Employee Growth = fib + ,Bi (% of smallfirms with patents) + e (3)

The data for Value Adjusted Growth, Gross Output Growth, and Full-Time Equivalent

Growth all came from the BEA website (bea.gov) by searching for GDP-by-industry data. I

calculated the percent of small firms that produced patents by taking the total amount of patents

produced by large firms ( 500 employees) and small firms in each industry and dividing thatnumber by the amount patents produced by small firms in each industry. By listing a percentage

rather than raw number, I am avoiding skewed results that may arise from comparing very large

industries such as healthcare to very small sub-industries like teaching aides, where the number

of patents in the former industry will naturally be much higher than the latter.

Table 1.1 - Descriptive Statistics

Variable Mean Median Minimum Maximum Std. Dev.

Va/A dGr98toO73 26.220 21.709 -29.703 123,52 34.507

GrossOutGr98toO7 19.011 11.263 -19.139 120.66 28.587

FTEEmpGr98toOY -2.1739 -6.7669 -29.874 38.158 21.058

Pc/Small 5.8220 4.2889 0.41459 16.495 4.0028

ValAdGr98toO7 and GrossOutGr98toO7 are measured in millions of dollars

FTEEmpGr9StoO7 is measured in thousands of employees

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IV. Results and Discussion

The regression results appear in Tables 21-2.3. Overall, the percent of patents produced

by small firms was insignificant on Value Added Growth (ValAdGr98toO7) and Gross Output

Growth (GrossOutGr98too7) across the 31 industries sampled. The Full-Time Employee Growth

(FTEEmpGr9StoO7) rate was positively correlated and statistically significant with a p-value of

5/b, giving the PctSmall two stars with a 95% confidence level.

Table 2.1 Regression Results

Dependent Variable: ValAdGr98to07Method: Least Squares

Variable Coefficient p-value

Constant* 21.3155 0.0661PctSmall 0.84244 0.6010

R-squared 0.00955vt ) Adjusted R-squared -0.024604

.%J& ,.jit * Significant at the .1 Type I error level


Dependent Variable: GrossOutGr98too7Method: Least Squares


Constant 15.5299 0.1053PctSmall 0.59798 0.6543

R-squared 0.0070 1Adjusted R-squared -0.02723

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Dependent Variable: FTEEmpGr9StoO7Method: Least SQuares


Constant**-137037 0.0397

PctSmall** 1.98040 0.0369

R-squared 0.141714Adjusted R-squared 0.112118* Significant at the .1 Type I error level** Significant at the .05 Type I enor level

The results suggest in tables 2.1 and 2.2, Value Added Growth (ValAdGr98toO7) and

Gross Output Growth (GrossOutGr98too7) do not seem to be affected by any increase in the

amount of patents produced by small firms across the 31 industries sampled. The results suggest

in table 2.3 that a one percent increase in patents produced by small firms (PctSmall) across all

31 industries will lead to an increase of 1.98 percent in fiJi-time equivalent employment

(FTEEmpGrQ8toO7).

V. Conclusion

This paper found that of the three variables I tested for different types of industry growth,

the only variable of significance was full-time employee growth. It is very possible that a 10 year

period was not long enough to see any sort of major or significant growth in the other two areas

tested, Value Added Growth and Gross Output Growth, and that employee growth is one of the

first indicators of a growing industry. I am under the presumption that by expanding the time

frame beyond a 10 year period to 25 or even 50 years by cross referencing NAICS codes to the

former industry standard SIC codes would give results that hold a higher significance level and9

nV

more insight to industry growth rates over the booms and busts of different sectors of the

American economy.

Filing and producing patents doesnt necessarily mean the product will be developed any

time in the near future, or even at all. Large corporations will often file patents with the intent of

never actually pursuing the development of the product, but more as a way to block other

companies, large or small, from using their technology. Patents are not cheap; obtaining one can (4d ,J iW1

cost anywhere from $5000 to S 15,000. Large firms are able to absorb this cost while receiving no

benefit from the patented product while their smaller counterparts may only find it necessary to

patent with the intent of actually developing the product. I would imagine this behavior has a

significant effect in skewing my data and would involve much deeper research to see the number

of patents filed by a company compared to the number of patents actually developed into final

products.

Perhaps these results are skewed, and are in line with both Rothaermels (2001) and

Baumols (2002) findings that small firms and large firms are often in communication and

collaborate with each other because both stand to benefit from one anothers unique skills and

assets. My findings are also in line with Chandy and Tellis (2000) paper as there seems to be no

display of the incumbents curse in my regression analysis.

There are obviously many more factors other than the amount of patents that small firms

produce that can be used to measure industry growth. I was motivated to write this paper based

on the debacle that has taken place at Kodak over the last 20 years. Since they failed to be an

innovative company when it mattered most, in the transfer from film to digital and with smaller

companies stepping up and taking Kodaks place, I was under the initial impression that small

firms were the engine behind innovation and growth. Perhaps if the data was collected over the

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smaller compaies stepping up and taking Kodaks place, I was under the initial impression that

small firms were the engine behind innovation and growth. Perhaps if the data was collected over

the earlier proposed 50 year period, growth could be seen and attributed to small firm innovation.

The longer time span could potentially offer valuable insight into the effectiveness of tax breaks

and subsidies that are given to small businesses and industries and whether or not they are

beneficial to industry growth.

1A.

/ 4

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Bibliography

Baumol, William J. 2001 Entrepreneurship, Innovation, and Growth: The David-GoliathSymbiosis. Journal ofEntrepreneurial Finance and Business 1-19

Baumol, William J. 2004. Education for Innovation: Entrepreneurial Breakthroughs vs.Corporate Incremental Improvements. NBER Working Paper Series.http:I/www. nber. org!papers/wl 0578

Breitzman, Anthony and Diana Hicks. November 2008. An Analysis of Small Business Patentsby Industry and Firm Size. Small Business Research Summary. No. 335http://www.sba.gov/aclvo

Bureau of Economic Analysis. 2010. GDP-by-lndustry Data.http://www.bea.gov/industry/gdpbyinddata.htm

Chandy, Rajesh K, and Gerard J. TeLlis. July 2000. The Incumbents Curse? Incumbency, Size,and Radical Product Innovation. The Journal ofMarketing. Vol. 64, No. 3

Hill, Charles W.L. and Frank T. Rothaermel. 2003. The Performance of Incumbent Firms in theFace of Radical Innovation. Academy ofManagement Review. Vol. 28, No. 2. 257-274

Knight, Russel M, July 1989. Technological Innovation in Canada: A Comparison ofIndependent Entrepreneurs and Corporate Innovators. Journal ofBusiness Venturing.Vol. 4, Issue 4. 28 1-288

Rothaermel. Frank T. June/July 2001. Incumbents Advantage Through ExploitingComplementary Assets via Inter-firm Cooperation. Strategic Management JournaLVol. 22, Issue 6-7, 287-299

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Documents

Effect of Small Firm Patents on Industry Growth