The effects of institutional quality and diversity of foreign markets on exporting firms’ innovation

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The effects of institutional quality and diversity of foreign markets on exporting firms’ innovation Jie Wu a,b,c,1, Zefu Wu a,*, Shuaihe Zhuo b a

College of Business Administration, Huaqiao University, Quanzhou 362021, China University of Macau, Avenida da Universidade, Taipa, Macau, China c Business School, Leeds University, UK b

A R T I C L E I N F O

A B S T R A C T

Article history: Received 19 April 2014 Received in revised form 28 January 2015 Accepted 3 May 2015 Available online xxx

This study examines the role of the institutional quality and diversity of foreign markets on exporting firms’ innovation performance. Building on the institutional economics theory, the institution-based view of international expansion, and the literature on international diversification, this study proposes that expanding into a foreign market with well-developed institutions helps exporting firms improve innovation performance and that a high degree of institutional diversity of multiple foreign markets positively influences firm innovation. The study also suggests that institutional diversity weakens the positive relationship between institutions and firm innovation. The findings provide support for the proposed hypotheses. Implications for both theory and practice are discussed. ß 2015 Elsevier Ltd. All rights reserved.

Keywords: Incremental innovation Institutional diversity Institutional quality Radical innovation

1. Introduction In an increasingly knowledge-based economy, not only is innovation a key strategy that helps firms compete and grow, but it also profoundly influences social and economic evolution (Eisenhardt & Tabrizi, 1995; Sorensen & Stuart, 2000). Understanding the factors that determine an organization’s ability to introduce new products and innovate continuously is therefore a primary objective of innovation studies. During the past few decades, scholars have increasingly emphasized the importance of institutions in affecting technological development and firm innovation (Furman, Porter, & Stern, 2002; Lundvall, 1992; Mahmood & Rufin, 2005; Mowery, 1984; Nelson, 1988). For example, Mahmood and Rufin (2005) suggest that the quality of a country’s marketsupporting institutions plays an important role on firm innovation by facilitating or curtailing the flow of ideas and knowledge spillovers across firms. Although this body of work focuses on how a country’s institutions affect firm innovation, it indicates little about how foreign market institutions affect firm innovation. Institution-based research on international expansion explicitly deals with foreign market institutions and posits that the

* Corresponding author. Tel.: +86 13599298498. E-mail addresses: [email protected] (J. Wu), [email protected] (Z. Wu), [email protected] (S. Zhuo). 1 Tel.: +86 853 8822 8887; fax: +86 853 8822 8887.

institutional settings of the foreign markets a firm enters significantly determine the efficacy of the firm’s strategic choices. Scholarly works in this research stream have examined institutional environments of host countries (e.g., Delios & Henisz, 2003; Pantzalis, 2001) and the variety of institutional environments across multiple foreign markets (e.g., Kostova, 1999; Kostova & Zaheer, 1999). However, scant research has investigated foreign countries’ institutional configurations that support innovation or explored how institutional quality in foreign countries affects exporting firms’ introduction of radical and incremental innovation. This lacuna is surprising because radical and incremental innovation are two classic types of innovation, and both occupy a central position in innovation and directly affect firm survival, profitability, and growth (Autio, Sapienza, & Almeida, 2000; Doran & Ryan, 2014; Eisenhardt & Tabrizi, 1995). Another related literature stream takes international diversification, or the extent to which a firm conducts value-adding activities in multiple different foreign markets, as its focal analysis. Here, scholars have attempted to determine whether and how a firm’s international diversification affects its innovation and/or financial performance (e.g., Autio et al., 2000; Hitt, Hoskisson, & Kim, 1997; Sapienza, Autio, & Zahra, 2006; Zahra, Ireland, & Hitt, 2000). Unfortunately, research results are ‘‘particularly inconsistent, with almost any conceivable outcomes showing up in at least some of the studies’’ (Verbeke & Brugman, 2009, p. 266). Scholars have more recently acknowledged missing sound theoretical backing for an appropriate measure of international diversification

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(e.g., Hennart, 2007). The inconsistency is largely due to the restricted conceptual treatment of international diversification, which has not fully incorporated the diversity of institutional environments in various foreign markets. This study addresses these fundamental concerns and brings disjointed research streams together by examining the roles of foreign market institutional quality and diversity on a firm’s innovation. Knowledge, economic, political, cultural, demographic, administrative, and other institutions are essentially multi-faceted (Berry, Guille´n, & Zhou, 2010). Given our specific interest in firm innovation performance, we focus on innovation-supporting institution, as prior studies have emphasized its critical role on firm innovation (Furman et al., 2002). Accordingly a foreign country’s institutional quality refers to the level or development of institutions that support innovation in its market, and institutional diversity of foreign markets refers to the diversity or inconsistency of institutional quality in all foreign markets of an exporting firm. We emphasize that an exporting firm’s innovation success depends not only on the development of institutions in a foreign market but also on the extent of diversity of institutional developments in all other foreign markets in which the exporting firm engages. Thus, this study focuses on (1) a foreign market’s institutional quality, by building on the institutional economics research that highlights the role of country-level institutions on firm innovation, and (2) the institutional diversity of multiple foreign markets, by combining international diversification literature with institution-based research on international expansion. This article makes several contributions to the literature. First, we expand the research on institutions and innovation, which has primarily focused on innovation-supporting institutions of the home market (Furman et al., 2002; Lundvall, 1992; Nelson, 1988), and we argue that a foreign market’s institutional quality is a critical but under-researched context for understanding the role of institutions in promoting firm innovation. Second, scholars holding the institution-based view of international expansion have explored the complexity of foreign markets but associated it mainly with the probability of organizational survival or financial performance (Gaur & Lu, 2007; Xu & Shenkar, 2002); conversely, other scholars have examined the innovation implications of international diversification but have fallen short of accounting for institutional diversity in theorizations and measurement (Autio et al., 2000; Hitt et al., 1997; Sapienza et al., 2006). This study fills these gaps in the literature by proposing the varying degrees of institutional quality of foreign markets as a key construct. The study further operationalizes this construct and empirically shows its implications for firm innovation. Third, this study is one of the first to examine how the quality and diversity of foreign markets’ knowledge institutions jointly affect a firm’s innovation. We selected China as the empirical setting for testing these propositions. Soon after its liberalization of trade and investment in the late 1970s, China rose to become one of the world’s largest economies and is an important trading partner for many economies, both large and small, developed and less developed. During the past three decades, Chinese firms have rapidly expanded into the global market through exports, strategic partnerships, and mergers and acquisitions. While many Chinese firms have expanded to foreign markets with well-developed institutions, such as the United States, Germany, and the United Kingdom, many other firms have expanded to foreign markets with under-developed institutions, such as Indonesia, Myanmar, and Nigeria. Moreover, some Chinese firms have expanded simultaneously to foreign markets with well-developed institutions and markets with under-developed institutions, thus facing different systems of institutional environments. This raises several fundamental questions: Are there different patterns of innovation between firms expanding to well-developed institutions and those

expanding to under-developed institutions? How does the institutional diversity of an exporting firm’s foreign markets affect its innovation? Moreover, how does the institutional diversity of all a firm’s foreign markets affect firm innovation? 2. Theoretical development Not only does innovation expand a firm’s existing technological knowledge set, but it also enhances its world knowledge set (Grossman & Helpman, 1991). Because innovation essentially involves the recombination of existing ideas (Weitzman, 1998), to innovate, a firm must engage in the task of managing the flow of resources and ideas. The flow of resources and ideas in a society is fundamentally affected by institutional configurations. Institutions are ‘‘the rules of the game in a society, or more formally, are the humanly devised constraints that shape human interaction’’ (, p. 3). Institutions are critical for firm innovation because they provide institutional contexts in which corporate governance can function effectively, facilitate the market transactions of firms and individuals (Meyer, Estrin, Bhaumik, & Peng, 2009), and shape the direction of the acquisition of knowledge and skills (Lin, Cai, & Li, 2001). Moreover, well-developed institutions ensure information transparency and contract enforcements and reduce agency costs, encouraging managers to adopt long-term strategic choices such as innovation (Mowery, 1984; Nelson, 1988). 2.1. Institutional quality of foreign markets The institutional economics literature has long emphasized the role of institutions on firm-level technological development and innovation (Mahmood & Rufin, 2005; Nelson, 1988). In their influential work, Mahmood and Rufin (2005) develop a model of the role of institutional quality in facilitating or hindering firm innovation and systematically explore how institutional quality affects the flow of resources as well as knowledge spillover for firm innovation. We extend this research stream to firm internationalization and innovation. With accelerated globalization, both international trade and foreign direct investment have increased. As a result, the institutional environments a firm faces are no longer limited to the home market but also include those of foreign markets. It is important to consider the institutional quality of foreign markets to which a firm is expanding. These markets include host markets with developed institutions, host markets with underdeveloped institutions, and host markets between the two extremes (Mahmood & Rufin, 2005). The institutions of a host market not only determine the level of innovation but also influence firm-level comparative advantage and exporting (de Groot, Linders, Rietveld, & Subramanian, 2004; Dollar & Kraay, 2003; Francois & Manchin, 2006; Gao, Murray, Kotabe, & Lu, 2010; Levchenko, 2007). Compared with a domestic firm that is constrained to the home market, a firm expanding overseas is exposed to foreign markets whose institutions vary in their level of development—that is, various host countries have different levels of institution quality. As such, an exporting firm encounters a more complex institutional environment than a purely domestic firm (Kostova & Zaheer, 1999). The competitive advantage of an exporting firm now depends not only on its home-grown capabilities but also, and more importantly, on its ability to effectively cope with diverse institutional environments. Exporting firms that can take advantage of a host market with high-quality institutions will likely be more successful in developing new products than firms that fail to do so. 2.2. Institutional diversity across foreign markets The comparative institutional literature suggests that organizations face institutional complexity when they confront

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multiple, often conflicting institutional logics that interact and compete with one another (Greenwood, Raynard, Kodeih, Micelotta, & Lounsbury, 2011; Hall & Soskice, 2001). In international business, many firms compete not only in a single foreign market but in multiple markets as well. These firms are likely to face varying institutional environments across multiple foreign markets. In their institutional comparison of major Asian business systems, Witt and Redding (2013) suggest that a dichotomous approach to institutional comparison is not applicable to Asia, because the Asian business system is different from that in the West. Westney (1993) suggests that firms face multiple country institutional environments, each of which is unique. The structure of these institutions typically varies across national environments (Kogut, 1991). A key practice in this line of research is testing the effect of a wide variety of institutional environments on the legitimacy of multinational enterprises (Kostova, 1999; Kostova & Zaheer, 1999). However, researchers have mainly focused on the impact of complex institutional environments on firm survival, growth, and performance in host markets, while paying little attention to the possibility that foreign countries’ diverse institutional environments may have important impacts on firm innovation and may also shape the effect of these countries’ institutional quality. More fundamentally, despite the literature’s focus on institutional environments, researchers have not fully considered the degree of variety of institutional environments across multiple foreign markets. As Greenwood et al. (2011) note, relatively few studies have examined the degree to which institutional logics are incompatible. In general, previous research confounds the number of foreign markets with the variety of institutional environments across markets, assuming that the rules and regulations as well as government efficiency are country specific because they are created by local governments and are often the outcome of political processes (Kostova & Zaheer, 1999). Under this assumption, firms face as many different institutional environments as the number of countries in which they operate. The greater the number of countries, the greater is the variety of institutional environments to which the focal firm is exposed. This assumption may not be valid, however, because firms operating in many different foreign countries with very distinct levels of institutional developments will likely find it difficult to figure out institutional requirements in each country and transfer institution-based knowledge from one country to another than will firms operating in the same number of foreign countries but with similar levels of institutional developments (Lu, Tsang, & Peng, 2008). For example, consider a firm simultaneously interacting with five foreign markets, three of which have well-developed institutions (United States, Japan, and Germany) and two of which have underdeveloped institutions (Mali and North Korea). Now consider another firm interacting with the same number of foreign markets, all of which have similar levels of institutional development. The former firm faces a higher degree of diversity or inconsistency in the institutional environments than the latter, though the number of foreign markets is the same. As Greenwood et al. (2011, p. 332) note, ‘‘Given this inconsistency in extant research, a more explicit definition of ‘incompatibility’ appears warranted.’’ Collectively, these studies suggest that the more diverse the institutional environments of multiple foreign countries are, the more difficult it will be for firms to make sense of them all and respond appropriately in terms of their specific institutional requirements (Kostova & Zaheer, 1999). Consequently, exposure to multiple foreign markets with diverse institutional environments raises significant challenges for firms in developing capabilities and strategic directions. We conceptualize institutional diversity as the extent of the various developments of knowledge institutions across multiple

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foreign countries with which an exporting firm interacts. The construct of institutional diversity developed herein represents a more fine-grained concept: it is considered from a focal firm’s point of view, it goes beyond a single- or dyadic-level analysis to take into account many foreign markets, and it highlights the various institutional environments among multiple foreign markets. 3. Hypotheses 3.1. Institution quality of foreign markets and innovation Expanding to a foreign country with better-developed knowledge institutions can alleviate the institutional constraints that limit returns from innovation investments in the home market. Multinational enterprises rely on a variety of institutions (e.g., political, financial, cultural) to succeed. Among the most important institutions are technological institutions, which provide entrepreneurial opportunities for accessing new technologies through knowledge spillover. The literature on national systems of innovation (e.g., Furman et al., 2002) provides a comprehensive analytical framework on the quality of knowledge institutions for a comparative analysis of the countries in the area of technological innovation. The national innovation system proposes that the quantity of knowledge institutions helps countries transform resource inputs more efficiently into knowledge and, thus, innovation (Almeida & Kogut, 1999; Nelson & Rosenberg, 1993; Patel & Pavitt, 1994). When a country or region has strong knowledge institutions, firms operating in such a market are more likely to have better innovative performance. A better-developed knowledge institution requires strong enforcement of intellectual property rights in those countries, enabling firms to better protect their rights and collect income generated from innovation. By expanding to a foreign market with developed knowledgesupporting institutions, firms can take advantage of institutional advantages there (e.g., learning from local firms, achieving stronger intellectual property rights protection through efficient and transparent institutions), thus reaping the rewards from their innovation investments, which in turn greatly fuel their incentives to develop new products in that market. Because advanced technologies and a better-developed customer base tend to spatially concentrate in markets with innovation-supporting institutions (Makino, Lau, & Yeh, 2002; Yiu, Lau, & Bruton, 2007), expanding to these markets can provide foreign firms access to these strategic resources. Firms can learn about advanced technologies from doing business with partners in the host market, which can help promote successful innovation. They can also imitate or buy sophisticated technologies they could not make by themselves and combine these with home-grown capabilities (e.g., mass-production capability). Such combinations can spur firms to introduce new products to domestic and foreign markets and offer them at competitive prices (Yeung, 1997), which in turn will have a positive effect on innovation success. Firms are also forced to constantly develop new products to match swiftly changing demands of sophisticated customers (Lu et al., 2008). Moreover, developed innovation-supporting institutions strongly encourage level-playing-field technology and market competition (Lin et al., 2001). In a free competition market, ‘‘survival of the fittest’’ is the law, in the sense that whether a firm is deemed superior or inferior is determined by whether it can beat the competition (Alchian, 1950). Foreign firms have no choice but to compete head-to-head with local competitors that already possess strong technological capabilities. The fierce technology and market competitions push foreign firms to upgrade their technological capabilities; otherwise, they will be wiped out of the market. Thus, we propose the following:

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Hypothesis 1a. The institutional quality of foreign markets has a positive effect on both the radical and incremental innovation performance of an exporting firm. We propose that the positive effect of a foreign country’s institutional quality is stronger on an exporting firm’s radical innovation performance than its incremental innovation performance. Radical innovation entails radical changes in products and processes, whereas incremental innovation entails gradual changes in products and processes. Although incremental innovation may also benefit from exporting to a foreign country with high-quality institutions, it involves more activities that exploit existing knowledge and skills. In contrast, radical innovation requires active engagement of exploration to generate a wide range of ideas in new environments and markets. Thus, we predict the following: Hypothesis 1b. The institutional quality of foreign markets has a stronger positive effect on an exporting firm’s radical than incremental innovation performance. 3.2. Institutional diversity of foreign markets and innovation As noted previously, institutional diversity of foreign markets reflects the extent to which the developments of innovationsupporting institutions differ among a firm’s multiple foreign markets. Compared with firms interacting with one or two foreign markets with a low degree of institutional diversity, firms interacting with many foreign markets with a high degree of institutional diversity are exposed to a broader array of new, dissimilar institutional environments. Firms are therefore stimulated to experiment with different solutions and develop new approaches to adapt to the new institutional environments and to address the distinct institutional requirements, which can greatly increase firms’ flexibility and ability to effectively cope with these environments (Cuervo-Cazurra & Genc, 2008; Gaur & Lu, 2007). Moreover, diverse institutional environments expose firms to a wider range of new ideas and practices. The infusion of new ideas and practices provides firms with the opportunity to develop various products and technologies by redesigning and combining, thus sparking innovations and boosting technological capabilities (Barkema & Vermeulen, 1998; Luo & Tung, 2007). Finally, a high degree of institutional diversity of foreign markets confronts a firm with various demand characteristics and technological rivals and business partners (see Abrahamson & Fombrun, 1994; Miller & Chen, 1994). The additional information, combined with incentives for search in order to avoid failures in unfamiliar institutional environments, leads to a richer knowledge structure and stronger technology capabilities than it does for firms interacting with a few markets characterized by a low degree of institutional diversity (Barkema & Vermeulen, 1998; Wu, 2013). We expect the strong ability to cope with dissimilar institutional environments, along with enhanced technological capabilities, to increase firms’ innovation success. Hypothesis 2. The institutional diversity of foreign markets has a positive effect on both the radical and incremental innovation performance of an exporting firm. 3.3. The joint consideration of institutional quality and diversity Operating in foreign markets with various developments of innovation-supporting institutions requires firms to invest more resources and managerial attention so that they can build, develop, and retain institution-based knowledge in each market than operating in foreign markets with similar institutional developments. The more diverse the institutional developments among

the foreign markets with which a firm interacts, the more time the firm must spend on determining the local institutional requirements (e.g., legal, environment, and technological requirements) and the greater is the challenge in redesigning products and production processes to adapt to local conditions (Usunier, 1996). Rangan (2000) notes that when dealing with foreign markets with a high degree of institutional diversity, firms must commit substantial resources (both capital and attention) to each individual market to make sense of local technological requirements. Unfortunately, firms soon reach limits in terms of time and effort that they can devote to managing operations (Hitt et al., 1997). When interacting with many foreign markets with a high degree of institutional diversity, correctly understanding and interpreting their institutional requirements can become extremely costly, exceeding firms’ capacities. Consequently, the reduced resources and managerial attention will greatly limit firms’ ability to absorb sophisticated technologies and advance management practices in advanced markets, which usually require a deep understanding of the idiosyncratic institutional, technological, and cultural characteristics of a host market. Thus, interacting with many foreign markets with a high degree of institutional diversity will inhibit firms’ ability to effectively absorb advanced technologies of these markets, weakening the positive effect of foreign markets’ innovation-supporting institutions in promoting successful firm innovation. Markets at different stages of institutional development normally exhibit significant differences in technological requirements, market demand, and customer preferences, calling for distinct new product capabilities and strategies. In this situation, firms must bear additional costs of coordinating different structures and processes, which further constrain their ability to satisfy highly demanding technological requirements raised by sophisticated customers in an institutionally developed market (Vorhies, Morgan, & Autry, 2009). Trying to provide different products (e.g., low-tech vs. high-tech) for distinct customers located in different countries with different technological levels simultaneously can generate internal conflicts over resource allocations to develop different sets of capabilities (Burgelman, 1994; Pfeffer, 1981). Such conflicts in resource allocation and capability development required by a high degree of diversity impair firms’ potential to successfully develop novel products to match swiftly changing customer needs in markets with developed institutions. Therefore, the high degree of institutional diversity of many foreign markets weakens the enhanced effect of innovationsupporting institutions of a specific foreign market on firm innovation success. Hypothesis 3. The institutional diversity of multiple foreign markets weakens the positive effect of the countries’ institutional quality on both the radical and incremental innovation performance of an exporting firm. 4. Method 4.1. Data We tested the hypotheses by constructing a panel data from multiple sources. We obtained export information from the China Import–Export Trade Database provided by the General Administration of Customs of the People’s Republic of China (called ‘‘China Custom Data’’). The General Administration of Customs systematically tracked each transaction of export activities by firms operating in China market from 2000 to 2010. The data contain comprehensive information such as the name of exporting products, the units and amounts of the products, the value of the products, the destination country, and so on. However, China

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Table 1 Sample characteristics. Number of firms

Characteristics Firm size

Small Median Large

<1000 employees 1000–10,000 employees >10,000 employees

Firm age

Young Middle Old Total

<5 5–10 >10

Custom Data do not contain any information on the characteristics (e.g., firm age, employee number, ownership structure) of exporting firms. We obtained yearly firm-level financial and other information in the same period from China Security Market Accounting Research Database, which provides firm-specific information on all publicly listed Chinese firms. Finally, we obtained the patent information of firms from 2000 to 2010 from China’s State Intellectual Property Office and technological class from the World Intellectual Property Office. To match the first two sets of longitudinal data, we first identified each publicly listed firm’s unique custom identifier via China Customs’ Online Service Center. Then we used this unique custom identifier to link firmlevel financial data with China Customs’ Data. Next, we linked this matched data set with patent data, relying on the unique company name. The final sample contained an unbalanced panel data with 8486 firm-year observations in the 2000–2010 period. Of the sampled firms, approximately 61% were of medium size, and 32% were smaller, with fewer than 1000 employees. Approximately 44% had been in business between 5 and 10 years, with another 39% aged over 10 years and 17% aged less than 5 years (see Table 1). Table 2 lists information on the range of export markets and the order of their popularity. As Table 2 shows, 138 markets were reported as export2 markets. Hong Kong, Japan, and the United States are among the export markets most popular for Chinese firms, whereas Rwanda, Mali, Bolivia, Monaco, Haiti, and others are among those least popular for Chinese firms. Of the exporting firms, 80 (97%) exported to seven or more foreign markets, 85 (9%) to six foreign markets, 111 (12%) to five foreign markets, 120 (13%) to four foreign markets, 114 (13%) to three foreign market, 205 (23%) to two foreign markets, and 188 (21%) to one foreign market (see Fig. 1). 4.2. Measures 4.2.1. Dependent variable We measured a firm’s innovation performance in a year by the number of patents it acquired in that year. As Fig. 2 shows, the number of patents acquired by the Chinese sample firms increased over the years. To be consistent with our conceptualization, we divided innovation performance into two typologies: radical innovation performance and incremental innovation performance. We measured radical innovation performance by the number of completely new patents3 in terms of the existing technological domain that the firm was granted yearly. We defined technological domain in accordance with the three-digit technological classes implemented by World Intellectual Property Office. If a firm creates a new patent outside its existing technological classes, we

2 In China, firms with between 1000 and 10,000 employees are classified as medium-sized. Those with fewer than 1000 employees are small, and those with more than 10,000 employees are large. 3 There are three types of patents: invention patents, utility patents, and design patents. In general, invention and utility patents are more innovative than design patents. Therefore, we use invention and utility patents in the analyses.

Percentage

478 924 107

32 61 7

242 671 596 1509

17 44 39 100

consider it a radical innovation. We counted the total number of patents that a firm creates each year that is new for its technological domain, which we used to measure radical innovation performance. We measured a firm’s incremental innovation performance by the number of patents belonging to existing technological domains that the firm was granted yearly. We checked the total number of new patents that a focal firm had each year within its existing three-digit technological classes and used it to proxy a firm’s incremental innovation performance. 4.2.2. Independent variables Consistent with our conceptualization, we focus on institutional quality in terms of the innovation-supporting aspect. We obtained this innovation-supporting dimension of institutional quality from the cross-national distances in Berry et al.’s (2010) study. Prior studies have consistently used the knowledge dimension to capture a country’s innovation-supporting institutions (Furman et al., 2002; Nelson & Rosenberg, 1993). The literature on institutions and innovation suggests that countries have different innovation capacity, which has important implications for firm innovation and multinational enterprises’ location choice (Guler & Guille´n, 2010). Building on this insight, Berry et al. collected data from multiple sources (e.g., World Development Index, U.S. Patent and Trademark Office) to construct a cross-national knowledge distance measure to reflect country-level innovation institutions. As such, this measure is an appropriate proxy for innovationsupporting institution quality. We also measured institutional diversity by the standard deviation of innovation-supporting institutions across multiple foreign countries entered by focal firm i:

IDi;t ¼

vffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi io2 P unP h J J u IQ i; j;t  IQ i; j;t =J t j¼1 j¼1 J1

where IDi,t refers to institutional diversity of all focal firm i’s foreign markets at time t; IQi,j,t refers to institutional quality of foreign market j to which focal firm i exported at time t; and J is the total number of firm i’s foreign markets. Standard deviation is a common measure of diversity (e.g., Baskin, 1989; Bittlingmayer, 1998). 4.2.3. Control variables We controlled for several variables that can affect firm innovation performance. First, we controlled for firm-level R&D intensity, which we measured by the ratio of a firm’s R&D expenditures to its sales revenues. Second, because larger firms tend to have more resources to devote to innovative activities (Eisenhardt & Tabrizi, 1995), we controlled for firm size, which we measured by the logarithm of the number of employees. Third, we also controlled for firm age, which we measured by the number of years elapsed since incorporation. Fourth, we controlled for state ownership, which we measured by the percentage of equity that were state owned. Fifth, foreign ownership may serve as an

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Table 2 List of export markets and the number of Chinese export firms entered. Country Name

Freq.

Country Name

Freq.

Country Name

Freq.

Hong Kong SAR, China United States Japan Korea, Rep. Germany India Taiwan, China Singapore Thailand United Kingdom Vietnam Philippines Australia Spain Canada Pakistan Italy Saudi Arabia Netherlands Russian Federation France Belgium Turkey South Africa Iran, Islamic Rep. Bangladesh Brazil Macao SAR, China Syrian Arab Republic Mexico Egypt, Arab Rep. Sweden Sri Lanka Myanmar Israel Greece New Zealand Poland Switzerland Denmark Argentina Kuwait Yemen, Rep. Norway Hungary Mongolia

359 213 203 186 117 115 108 105 97 80 75 75 75 64 62 58 56 55 55 47 47 45 43 38 34 33 33 29 27 27 25 24 24 24 23 23 22 22 21 19 19 17 16 16 16 16

Venezuela, RB Kazakhstan Lebanon Finland Colombia Czech Republic Ukraine Portugal Chile Austria Ireland Jordan Panama Guatemala Peru Cambodia Korea, Dem. Rep. Ecuador Algeria El Salvador Mauritius Tunisia Morocco Cyprus Kenya Uruguay Ghana Dominican Republic Bahrain Slovak Republic Togo Malta Tanzania Kyrgyz Republic Uzbekistan Slovenia Jamaica Croatia Lithuania Zambia Libya Bulgaria Latvia Luxembourg Guyana Qatar

15 15 15 14 14 13 13 13 12 11 11 11 10 10 10 10 10 9 9 8 8 8 8 8 8 7 7 7 7 6 6 6 6 6 6 6 5 5 5 5 5 4 4 4 4 4

Papua New Guinea Benin Gambia, The Georgia Suriname Belarus Mozambique Fiji Trinidad and Tobago Dominica Cuba Senegal Afghanistan Guinea Ethiopia Reunion Iceland Madagascar Paraguay Uganda Seychelles Marshall Islands Antigua and Barbuda Mauritania Sierra Leone Comoros Nicaragua Tajikistan New Caledonia Congo, Rep. Mali Haiti St. Vincent and the Grenadines Belize Gabon Cook Islands Bermuda Aruba Rwanda Azerbaijan Maldives Turkmenistan Vanuatu Bolivia Monaco Brunei Darussalam

3 3 3 3 3 3 3 3 3 3 2 2 2 2 2 2 2 2 2 2 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1

Notes: Based on a sample of 1509 firms and 8486 firm-market observations.

Fig. 1. Distributions of the sampled firms by number of export markets.

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40000

Number of Patent Granted

35000 30000 25000 20000 15000 10000 5000 0 2001

2002

20033

2004

20005

2006

2007

2008

2009

2010

Fig. 2. The number of patents granted to the sampled firm in the 2001–2010 period.

Table 3 Descriptive statistics. Unit

Description

Sources

0.87

2.00

Count number

12.61

64.03

Count number

Institutional quality

3.05

9.20

Index

Calculated by the authors from SIPO, China Calculated by the authors from SIPO, China Calculated by the authors from Berry et al. (2010) and GAC

Institutional diversity

1.70

3.90

Index

10.29 0.02

4.61 0.07

Year Ratio

State ownership

0.20

0.24

Ratio

R&D intensity

0.003

0.03

Ratio

Return on assets Economic distance

0.64 7.72

0.47 15.91

Ratio Index

Culture distance

6.44

10.04

Index

2211.96

3819.39

Index

The number of patents granted that enter into 3-digit new technology class The number of patents granted that have the same 3-digit technology class The knowledge distance among all the exporting countries weighted by export shares Standard deviation of knowledge distance across countries The number of years since the establishment The share of foreign-owned equity over total equity The share of state-owned equity over total equity The ratio of a firm’s R&D expenditure to total sales The ratio of a firm’s revenue to total assets The economic distance among all the exporting countries weighted by export shares The cultural distance among all the exporting countries weighted by export shares The geographic distance among all the exporting countries weighted by export shares

Variable Radical innovation Incremental innovation

Firm age Foreign ownership

Geographic distance

Mean

S.D.

Calculated by the authors from Berry et al. (2010) and GAC CSMAR CSMAR CSMAR CSMAR CSMAR Calculated by the authors from Berry et al. (2010) and GAC Calculated by the authors from Berry et al. (2010) and GAC Calculated by the authors from Berry et al. (2010) and GAC

Notes: Based on a sample of 1509 firms and 8486 firm-market observations. GAC denotes the General Administration of Customs of the People’s Republic of China, which provides the China Import-Export Trade Database. CSMAR denotes the China Securities, Market and Accounting Research database provided by GTA, a leading global provider of China financial market data. SIPO denotes the State Intellectual Property Office.

important link between home and foreign markets, helping firms develop the competencies and networks they need when expanding overseas. A foreign owner can also better gauge the business risks associated with foreign markets (Bhaumik, Driffield, & Pal, 2009; Chen & Chen, 1998). Thus, we also controlled for foreign ownership, which we measured by the overall percentage of equity owned by foreign investors. Given that institutions are multi-dimensional, in addition to the knowledge dimension, we controlled for other institutional dimensions, including economic, cultural, demographic, and geographic. We obtained these national-level data from Berry et al. (2010). According to Berry et al., the economic institution captures differences in economic development and macroeconomic characteristics. Cultural distance captures the differences in attitudes toward authority, trust, individuality, and importance of work and family, which was calculated using the Mahalanobis distance of Hofstede’s (2001) four dimensions: power distance,

uncertainty avoidance, individualism, and masculinity. Demographic distance captures differences in demographic characteristics, and geographic distance captures the geographic distance between countries. The sample contains firms from 17 manufacturing industries. To control for industry effects, we created 16 industry dummy variables. We also included nine year dummy variables to control for year effects. Table 3 reports the descriptive statistics on the key variables. 4.3. Statistical modeling The primary objective was to examine the effect of institutional quality and institutional diversity of foreign markets, as well as their interaction effect, on exporting firms’ innovation performance. Because the dependent variable is innovation performance measured by the number of patents, ordinary least squares will

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8 Table 4 Correlation table.

1 2 3 4 5 6 7 8 9 10 11 12

Variables

1

2

3

4

5

6

7

8

9

10

11

12

Radical innovation Incremental innovation Institutional quality Institutional diversity Firm age Foreign ownership State ownership R&D intensity Return on assets Economic distance Cultural distance Geographic distance

1.00 0.33 0.05 0.17 0.06 0.03 0.09 0.01 0.09 0.06 0.05 0.03

1.00 0.02 0.02 0.06 0.02 0.04 0.02 0.11 0.01 0.01 0.01

1.00 0.49 0.15 0.02 0.00 0.04 0.05 0.50 0.49 0.44

1.00 0.05 0.00 0.00 0.02 0.03 0.60 0.62 0.56

1.00 0.02 0.04 0.01 0.04 0.03 0.04 0.05

1.00 0.10 0.01 0.04 0.01 0.01 0.01

1.00 0.01 0.02 0.02 0.01 0.02

1.00 0.07 0.02 0.00 0.01

1.00 0.06 0.07 0.05

1.00 0.20 0.40

1.00 0.18

1.00

Notes: The results are based on a sample of 1509 firms and 8486 firm-market observations.

Table 5 Negative binomial regression analyses of radical and incremental innovation performance. Variables

Constant Firm age Foreign ownership State ownership R&D Intensity Return on assets Economic distance Culture distance Geographic distance Selfcorrection (l) Industry dummy Year dummy Institutional quality

Models M1

M2

M3

M4

M5

M6

Radical

Radical

Radical

Incremental

Incremental

Incremental

2.79*** (9.88) 0.17*** (11.01) 1.75*** (4.30) 0.82*** (8.34) 1.34 (1.47) 1.33*** (17.23) 0.01** (2.50) 0.01 (1.38) 0.01 (1.11) 16.70*** (15.50) Included Included 0.01*** (3.79)

2.74*** (9.95) 0.17*** (11.36) 1.63*** (4.06) 0.84*** (8.74) 1.75* (1.88) 1.39*** (18.45) 0.01* (1.93) 0.01** (2.22) 0.01*** (4.05) 17.49*** (16.61) Included Included

2.76*** (10.14) 0.17*** (11.50) 1.76*** (4.41) 0.84*** (8.89) 1.74* (1.90) 1.38*** (18.60) 0.01 (1.06) 0.03*** (4.83) 0.01*** (5.62) 17.25*** (16.62) Included Included 0.05*** (10.14) 0.21*** (15.71) 0.01*** (10.89) 9527.81 19,131.63 1085.80 0.00

6.22*** (17.92) 0.21*** (11.60) 3.07*** (5.76) 0.57*** (4.13) 9.88*** (4.87) 2.32*** (23.07) 0.01* (1.94) 0.00 (0.56) 0.01 (0.40) 25.47*** (17.93) Included Included 0.01 (1.61)

6.22*** (18.12) 0.22*** (11.81) 3.04*** (5.75) 0.55*** (4.02) 10.38*** (5.11) 2.38*** (23.67) 0.01** (2.01) 0.01* (1.66) 0.01 (0.21) 26.11*** (18.57) Included Included

6.21*** (18.11) 0.21*** (11.73) 3.11*** (5.89) 0.53*** (3.90) 10.33*** (5.09) 2.36*** (23.64) 0.01 (1.37) 0.02*** (2.61) 0.01 (1.02) 25.86*** (18.45) Included Included 0.04*** (5.16) 0.14*** (7.71) 0.01*** (5.96) 17,771.29 35,618.57 1395.08 0.00

0.14*** (14.04)

Institutional diversity Institutional quality  diversity Log-likelihood AIC LR x2 Prob. > x2

9707.61 19,487.22 726.21 0.00

9591.02 19,254.05 959.38 0.00

0.09*** (6.45)

17,812.37 35,696.74 1312.92 0.00

17,788.39 35,648.79 1360.87 0.00

Notes: The results are based on a sample of 1509 firms and 8486 firm-market observations. t-Value are in parentheses. *** Statistically significant at 0.1%. ** Statistically significant at 1%. * Statistically significant at 5%.

cause biased estimates. Thus, we employed the negative binomial model (Agresti, 2002). The negative binomial model is specified as E½yi jxi ; ei  ¼ expða þ x0i b þ ei Þ ¼ hi li hi ¼ expðei Þ  Gamma Distribution; where yi is the patent count number, E is the conditional expectation, xi is the vector of explanatory variables, a is the constant, b is a vector of parameters, and ei is the random error term. More specifically, we assume that hi has a gamma distribution with one parameter. The conditional expectation of

yi on xi is E[yijxi] = li. We estimated the negative binomial model by the maximum likelihood method. However, endogeneity may be a concern because it seems likely that innovation drives internationalization. In this regard, exporting to foreign markets may be in response to innovation, which leads to a two-way interaction between innovation and internationalization in the way innovation and internationalization are simultaneously determined. So, we take two procedures to avoid this problem. First, innovative performance is less likely to have reverse causality effects on the lag explanatory variables, so we lagged all the explanatory variables one year. Second, we followed Shaver’s (1998) two-step method to account for the endogeneity problem. In the first step, we regressed strategy choice variables

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(0 = no export, 1 = export) by performance on a set of independent variables, including firm age, firm size, R&D intensity, and foreign and state ownership. Following Shaver’s formula, we obtained a self-correction variable lambda (l). We then entered this variable into the second stage of the negative binomial regression. 5. Results Table 4 reports the descriptive statistics of the variables used in the analyses. The correlation between radical innovation and incremental innovation is 0.33; the correlation between radical innovation and institutional quality is 0.05. More generally, a review of the correlations among the independent variables suggests that multicollinearity is not a major concern. Table 5 provides the estimation results for Hypotheses 1a, 1b, 2, and 3, where M1–M3 reports the results of radical innovation, and M4–M6 reports the results of incremental innovation. M1 and M4 include the control variables and the main effect of institutional quality, M2 and M5 include the main effect of institutional diversity, and M3 and M6 are full models that include the main effects of institutional quality and diversity and their interaction effect. To reduce the potential for multicollinearity, we meancentered the predictor and moderator variables before creating the interaction term (Aiken & West, 1991). We used the two full models (M3 and M6) to interpret the hypotheses testing results.

9

Hypothesis 1a predicts a positive effect of a foreign market’s institutional quality on exporting firms’ innovation. The coefficient of institutional quality is positive and significant (M3: b = 0.05, p  0.001; M6: b = 0.04, p  0.001), indicating that institutional quality positively affects exporting firms’ innovation, in support of Hypothesis 1a. To test Hypothesis 1b, we conducted the seemingly unrelated test between models (M3 vs. M6). The statistics follow the chi-square distribution with one degree of freedom. The value of the chi-square statistic is 5.10 (p  0.02), which is significant at the 5% level, lending support to Hypothesis 1b. Hypothesis 2 predicts a positive relationship between foreign markets’ institutional diversity and exporting firms’ innovation. The coefficient of institutional diversity is positive and significant (M3: b = 0.21, p  0.001; M6: b = 0.14, p  0.001), indicating that institutional diversity positively affects exporting firms’ innovation, in support of Hypothesis 2. Hypothesis 3 predicts that foreign markets’ institutional diversity weakens the positive relationship between the institutional quality of a foreign market and exporting firms’ innovation. The interaction effect of institutional quality and institutional diversity is negative and significant (M3: b = 0.01, p  0.001; M6: b = 0.01, p  0.001). This result shows that the institutional diversity of a firm’s foreign markets weakens the positive effect of the institutional quality of a specific foreign market on its radical and incremental innovation. To further delineate the interpretation, we plot the interaction effects in

1.4

Radical innovatioon

1.2 1.0 0.8 0.6 0.4 0.2

Low diversity

High diversity

0.0 High

Low

Institutional quality Fig. 3. The institutional quality of foreign markets and exporting firms’ radical innovation performance.

25.0

Incremental innovatioon

20.0

15.0

10.0

5.0 Low diversity

High diversity

0.0 High

Low

Institutional quality Fig. 4. The institutional quality of foreign markets and exporting firms’ incremental innovation performance.

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Figs. 3 and 4, following Aiken and West’s (1991) method for linear models. In doing so, we constrain all the variables in M3 and M6 to their mean values, except institutional quality and institutional diversity. Institutional diversity took the values of one standard deviation above and one standard deviation below the mean, and institutional quality took the continuous values, respectively. In Figs. 3 and 4, the horizontal axis represents a foreign market’s institutional quality, and the vertical axis represents firm incremental innovation. As Figs. 3 and 4 show, at low levels of institutional diversity, the positive relationship between institutional quality of a specific foreign market and firm radical/ incremental innovation increases steeply; in contrast, at high levels of institutional diversity, the slope of this positive relationship increases only slightly. Thus, Hypothesis 3 receives additional support. 6. Discussion and conclusions 6.1. Theoretical contributions and implications Building on institutional economics theory, the institutionbased view of international expansion, and the literature on international diversification, this study investigated the effects of institutional quality and institutional diversity of foreign markets on exporting firms’ innovation performance. As predicted, the results show that both the quality and the diversity of innovationsupporting institutions positively affect exporting firms’ innovation performance, though diversity weakens the positive effect of quality on firm innovation. The findings contribute to extant literature in several major ways. Our work builds and extends research on institutions and innovation. Previous research has highlighted the important role of the institutional level of the home market in promoting technological development and firm innovation (Furman et al., 2002; Lundvall, 1992; Mahmood & Rufin, 2005; Mowery, 1984; Nelson, 1988). The evidence of the importance of a foreign market’s institutional quality in enhancing firm innovation demonstrated in this study confirms that country-level institutions play a critical role in promoting firm innovation. More generally, we add to this work by turning our attention to institutions of a foreign market. In doing so, we take lessons from the institution-based view of international expansion, according to which institutional settings of a foreign market significantly shape the efficacy of a foreign firm’s strategic choices (Gaur & Lu, 2007; Kostova, 1999). Building on this research, we argue that a foreign market’s high level of innovation-supporting institutions provides exporting firms access to advanced technologies and know-how, helps them collect income from R&D investments, and enhances their reputation and brand image, all of which exert positive effects on successful innovation. The results clearly show that a foreign market’s institutional quality improves exporting firms’ innovation performance. These findings extend current institutional analysis from the home market to the host market. To our knowledge, no other research has matched the level of institutional quality of a foreign market to firm-level innovation. Additional research is necessary to explore the effect of a foreign market’s institutional quality on firm innovation outcomes in other contexts. In addition, we extend research in this area by going beyond predicting the direct effect of institutional quality to outlining its boundary condition. We predicted that the positive effect of a foreign market’s institutional quality on firm innovation would be stronger for firms expanding to a few foreign markets with similar institutional settings. In contrast, the positive effect of a foreign market’s institutional quality is less significant for firms expanding to multiple foreign markets with distinct institutional developments. This suggests the need to examine not just one focal foreign

market and its institutional characteristics but also all a firm’s foreign markets and the institutional inconsistencies among them, when predicting firm innovation. Equally important, the introduction of foreign market institutional diversity adds to current efforts in the institution-based view of international expansion that have attempted to provide a more differentiated depiction of the complex institutional environment. The construct and the underlying mechanisms are applied to predict firm innovation. We develop the hypotheses to make explicit the conceptual linkage between institutional diversity of foreign markets and firm innovation, a vital issue that has remained largely unaddressed in the literature. Empirically, we operationalized this construct using a large sample of Chinese exporting firms. We clearly show the significance of the proposed construct and measure through its direct effect on firm innovation as well as its moderating role in the relationship between foreign market institutional diversity and firm innovation. This study also contributes to the literature on international diversification. The prevailing stream of research on the effects of international diversification on firm financial and/or innovation performance pertains either to the number of foreign countries (e.g., Lu & Beamish, 2004) or foreign sales over total sales (e.g., Ruigrok & Wagner, 2003) or to an entropy measure of foreign sales across markets (e.g., Zahra et al., 2000). In each of these modes of analysis, institutions are taken as given, and a firm’s multiple foreign markets confer environmental complexity. In contrast, this study focuses on the institutional dimension of diversification. We argue that a firm engaging in international diversification may face diverse institutional environments that differ from the number of foreign markets, and this disjuncture has implications for firm innovation behavior. What most distinguishes the current approach to international diversification from the general approaches employed in other studies is its specification from the outset of the degree of institutional diversity of a firm’s multiple foreign markets stemming from international diversification. In particular, knowing the degree of institutional diversity in foreign markets generates clear expectations for how the firm should relate institutional complexity to innovation. Consistent with this proposition, the results show that institutional diversity has a positive effect on exporting firms’ innovation and, moreover, weakens the positive effect of a foreign market’s institutional quality on firm innovation. Accordingly, rather than the number or foreign sales across a firm’s foreign markets, the causal spark in our analysis lies in the institutional aspect of international diversification (i.e., the institutional diversity of foreign markets), which has the potential not only to provide theoretical backing but also to guide efforts toward a more precise, institution-based measure of international diversification. Most important, in studying firm innovation we show the complementarity of two prominent but seemingly disjointed theories: the institutional economics research on institutions and innovation (Mahmood & Rufin, 2005; Mowery, 1984; Nelson, 1988) and the institution-based view of international expansion (Kostova, 1999; Kostova & Zaheer, 1999). To our knowledge, this study is the first to consider the joint effect of a foreign market’s institutional quality and multiple foreign markets’ institutional diversity on firm innovation. We proposed that a high degree of institutional diversity across a firm’s foreign markets would give the firm a wide range of opportunities, thereby lessening the positive influence of the institutional quality of a specific foreign market; the empirical findings offer support to these arguments. The joint consideration of these two constructs calls for theoretical integration of the two important theories in studying firm innovation. The analytical combinations of one- and multiplemarket levels also highlight the usefulness of applying levels to predict firm innovation success.

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6.2. Implications for practice

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For international managers, the findings highlight the importance of understanding the level of institutions of a host country, as a foreign market’s institutional quality clearly affects the firm’s ability to acquire advanced technologies, recoup R&D investments, and enhance its reputation and brand image. However, managers should also be aware of the limitations of a foreign market’s institutional level in boosting innovation success. When dealing with a wide variety of institutional environments, managers should understand that a high degree of institutional diversity provides many opportunities and increases flexibility in market choices, greatly reducing firms’ dependence on any one market. Therefore, when designing their firms’ foreign market strategies, managers should search for some degree of market diversity and also consider allocating more resources and attention to markets with more advanced innovation-supporting institutions. Such a foreign country portfolio would likely be the most beneficial for their firms’ innovation success. For public policy makers, the governments of many emerging market countries (e.g., China, India) still use preferential policies to encourage their home country firms to participate in global competition. The study’s findings provide support for the utility of such policies by showing that exposure to developed institutions can significantly facilitate innovation. However, policy makers should improve their own institutional quality and establish a free and open market system. Doing so would help local firms augment and develop firm-specific advantages and strengthen innovation capabilities, so that they can better participate in and benefit from competition in global markets.

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6.3. Limitations and further research As do most studies, we acknowledge that this study has limitations that may open up avenues for further research. First, we limited our analysis of innovation to the export. Given that export is not the only internationalization strategy, we suggest that further research should extend our theoretical framework to other contexts, such as foreign direct investments, and investigate the role of institutional quality and diversity of foreign markets in promoting successful innovation. Second, we used Chinese firms in our empirical analyses because these firms share some common features in their institutional development with firms from other emerging markets. However, we still need to be cautious in our generalization of the findings, as emerging market firms vary greatly in the stages reached. Thus, we suggest that further research test our models using data from firms in other emerging markets and developed markets to obtain greater generalizability. In conclusion, this study sheds light on the relationship between institutional quality and diversity of foreign markets and exporting firms’ innovation performance. The results show that both the quality and the diversity of foreign markets positively affect firm innovation. Moreover, the positive relationship between a foreign market’s institutional quality and firm innovation weakens when a firm faces a high degree of institutional diversity across multiple foreign countries. We hope that these findings advance existing knowledge of how firms can gain innovation benefits from exporting to complex institutional environments. Acknowledgments The authors would like to acknowledge the financial support provided by Chinese Social Science Fund (#14BGL029) and Education Ministry Fund of China (#12YJA790147) for this research.

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Please cite this article in press as: Wu, J., et al. The effects of institutional quality and diversity of foreign markets on exporting firms’ innovation. International Business Review (2015), http://dx.doi.org/10.1016/j.ibusrev.2015.05.001