MSc Management

Assignment Cover Sheet

Submitted by: 0860091

Date Sent: 29th June 2009

Module Title: Entrepreneurship and Business Venturing

Date/Year of Module: May 2009

Submission Deadline: 29th June 2009

Number of Pages: 11

Word Count: 2643

Question: “Innovation needs huge resources – so it’s largely the role of larger firms.
Discuss with reference to concepts, evidence and cases you have encountered during
the module.”

“All the work contained within is my own unaided effort and conforms to the
University's guidelines on plagiarism.”

Student ID: 0860091 Page 1

This paper aims to answer the fundamental question of whether innovation needs a large
amount of resources and whether it is an activity seen primarily in large firms. It attempts to
show an overview of innovation activity from all over the world with empirical evidence and
supporting views from academicians and scholars. While trying to answer the above
mentioned question, the paper also explores barriers to innovation for small firms which
gives rise to the notion that innovation is seen less in them than larger ones. Finally, the paper
aims to address the issue of whether the comparison itself is relevant and if innovation should
be viewed in a more microscopic manner rather than broadly classifying innovation as the
same for small and large firms.

Innovation – Small Firms v/s Large Firms

One of the earliest recognized works on the relation between innovation and firm size was
written by J. Schumpeter. In his article The Theory of Economic Development, he describes
technological change as a process of ‘creative destruction’ (Schumpeter, 1934). This meant
that market power was often temporary and that technologies could be easily challenged by
new innovative entrants. His research presented evidence to support this view, and showed
that small firms had a much larger number of innovations than large ones (Audretsch, 2002).
However in another published work (Schumpeter, 1950), his research suggests that since
innovation has become routinized over the past few decades, firms needed to exploit scale
economies and diversify their risk by innovating in different areas which would only then
give them a clear advantage over rivals. It can be inferred then, that these types of firms
would be large/ monopolist, since a considerable amount of resources would be needed to
satisfy the above mentioned conditions. (Galbraith, 1957) argued in favour of this view and
this is evident from the following quote taken from the work of (Audretsch, 1993):

“Because development is costly, it follows that it can be carried on only by a firm that has the
resources which are associated with considerable size.” - Galbraith, 1957

Recent evidence on innovation and firm size shows that number of innovations in large firms
surpasses that of smaller firms. The table shown below is from the OECD Innovation Micro
data project in 2008 which aims to exploit harmonised firm-level data from innovation
surveys for economic analysis (OECD, 2008). The project surveyed the below mentioned
countries from 2002-2004 and found that in all the measured countries the number of large
firms which came up with product or process innovations was far greater than small ones.
(See Figure 1)

The survey also analyzed how much innovation was contributing to overall turnover for
differently sized firms. Once again, barring the exception of Australia, larger firms generate
more of their turnover through innovations than smaller firms. (See Figure 2). The figures
provide strong evidence in favour of large firms as leaders in innovation.

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Figure 1 (Source: OECD Innovation Microdata Project, 2008
2008)

Figure 2 (Source: OECD Innovation Microdata Project, 2008)

There is yet more evidence to show that innovation is dependent on firm size and increases
proportionately with firm size. Data published by the National Institute of Statistics shows the
size distribution of Italian firms with innovation by size class from 2002 to 2004 (See figure
3). The statistics show that there is no innovation in extremely small firms (presumably start
start-
ups) and innovation increases proportionately as firm size is increased (Firm size measured
by employee count). (Hall et al, al 2009) support this evidence with findings suggesting that
there exists a positive relation between firm size and the likelihood of having product or
process innovation. The findingsngs are somewhat ambiguous as an unclear distinction is ma made
between R & D and innovation, and a negative correlation between firm firm size and R & D is
reported.

Figure 3 (Source: Innovation and productivity in SMEs: empirical evidence for Italy
Italy, Hall
(2009))
There however, also appears to be conclusive evidence in favour of the view that innovation
is dependent on industry, and not on firm size. Studies done on the manufacturing industry in
the USA by Acs and Audretsch (1987, 1988, and 1990) show that even though innovations in
large firms
rms were greater than smaller ones in absolute terms, the human resource employed
was far less in the smaller firm giving an innovation rate of 0.309 for small firms and 0.202
for the larger ones. The inference drawn by him was:

“Industries which are capital--intensive,

intensive, concentrated and advertising intensive tend to
promote innovation in large firms. The small firm innovation advantage however tends to
occur in industries in the early stages of the life-cycle,
life cycle, where total innovation and the use of
skilled labour
abour play a large role.”

Further studies by Audretsch (1995) again reveal figures which are inconclusive for deciding
whether innovation is strongly linked with firm size. Rather, they support the view that
innovation is industry specific,, and small firms can in fact innovate better than their larger
rivals in some industries. Audretsch (2002) further elaborates that this evidence corresponds
to ‘the notion of distinct technological regimes; that is, the routinized and entrepreneurial
technological
nological regimes.’ Winter (1984) explains the definition of such a regime as “An
entrepreneurial regime is one that is favorable to innovative entry and unfavorable to
innovative activity by established firms; a routinized regime is one in which the cond
conditions
are the other way around.” The data shown below is consistent with Acs and Audretsch’s
(1987) earlier theory as well, which describes capital intensive industries (In this case:
Aircraft, Food Products Machinery etc. ) as promoting innovation in large
large firms and skilled
labour intensive industries (In this case: Electronics computing equipment, Instruments to
measure electricity etc.) as promoting innovation in small firms.

Figure 4 (Source: The dynamic role of small firms:

firms: evidence from the US. Small Business
Economics, Audretsch,(2002))
Further support for small firms is given by Tether (2000), where he terms technologically
innovative firms as ‘special’. While acknowledging that small firms cannot contribute as
much as large ones in terms of sales and employment, he nonetheless recognizes them as
important for economic growth contributi
contribution.
A slightly different take on innovation and size comes from some scholars where they iterate
that small firms are largely responsible for contributing to the performance of large firms
through the provision of specialized equipment (Pavitt, 1984) and services (Soete et al, 1989).
Pavitt mentions that small and large firms are complements to each other and so should be
equally recognized for innovation (Pavitt, 1984). He argues:

“The other important sources of process innovations in [large] production-intensive firms

are the relatively small and specialised firms that supply them with equipment and
instrumentation, and with whom they have a close and complementary relationship.”

Rothwell (1983) expresses a similar view and terms it as ‘dynamic complementarity’. He

goes on to say:

“Large and small firms are a necessary complement to each other, rather than alternatives.”

Yet, some more evidence points to innovation being ‘valued’ differently at different points in
the product life-cycle, and suggests that the innovation-size relationship is a dynamic one.
Research suggests that small firms may be able to sustain a competitive advantage in markets
which are not well established and niche industries. However, when a product is launched
and starts to establish itself, the focus shifts from hard core innovation to exploiting
economies of scale, cutting production costs and streamlining the process in general. This
activity of ‘routinizing’ (Deakins et al., 2003) the process may be more suited to large
companies, and therefore offers and explanation as to why small firms enjoy success in
‘embryonic’ industries (Deakins et al., 2003), while larger firms are highly successful in
terms of sales and employment opportunities in mature industries where returns are quite
obviously greater.

The empirical evidence and data provided by many scholars over the past few decades
represent conflicting schools of thought. Although large firms dominate in terms of numbers,
there is nonetheless leading edge innovation activity in small firms. It can be established
however, that in resource heavy industries, large firms are clearly at an advantage. This does
not necessarily mean however that innovation is of any less importance in small firms, nor
does it mean that large resources are needed for innovation. In industries where ‘brains’ and
skill are needed more than infrastructure, research shows that small firms have carved quite a
niche for themselves. For example, in recent years, the software industry showed a lot of
support for young innovators. Some of the most revolutionary ideas were started with almost
no capital e.g. Hotmail. The most relevant debate is whether small firm innovation v/s large
firm innovation is really a valid comparison. In my opinion, the two should be treated entirely
separately as their contributions will most certainly be varied; in terms of number and in
terms of business goals.

Reasons for limited innovation in small firms

Although there is no ‘winner’ in the innovation battle between differently sized firms, it is
evident that small firms do face many difficulties in supporting innovation. Rothwell and
Dodgson (1984) offer a concise table of advantages and disadvantages small firms face.
Although the details described are not very relevant in this case, it can be inferred that the
advantages for small firms are mainly behavioural and the disadvantages relate to resources

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(Deakins et al., 2003). This brings us back to the question presented which asks if innovation
needs large resources. In most cases the answer is - Yes. Although the evidence and scholarly
views I have presented above do give credit to small firm innovation, there are many barriers
to overcome and many start-ups may fail due to their inability to get funding, human capital,
infrastructure etc. I have used some academic literature to explain some of the barriers to
small firm innovation, but have also added my own perspectives which are of particular
relevance to the current economic climate we are facing which may assist small firms in
viewing their environment differently.

Financing
Financial constraints can prove to be a major hurdle for small firms wishing to create a new
market through a new innovative product or service (Hewitt-Dundas, 2006). The reason
behind this is the fact that these new ventures are impossible to value accurately. By being a
‘first mover’, there can be several advantages, but also a considerable downside. Technical,
customer and environmental uncertainties (Hisrich et. al, 2005) make it difficult for potential
investors like venture capitalists and banks to assess the risks involved. Therefore certain
innovations may not be able to enter the market at all and this may further discourage the
entrepreneur to continue innovating or improving products. In certain cases angel investors
may decide to invest in a new project, but at a high interest rate or for a high stake in the
company. Research suggests that angels may ask for between 10% and 50% of a company’s
equity (Source: http://www.entrepreneur.com/money/howtoguide/article52742.html). This
effectively reduces profits for the original owner and can act as a de-motivator to innovation.
Similarly, banks adopt a system of “Credit rationing” which categorizes borrowers on the
probability of getting a return on the loan offered (Stiglitz et. al, 1981). For a high risk
venture like a new innovation, the lending rate would be exceptionally high and the real rate
of return for the firm may deter entrepreneurs from pursuing heavy innovative activity.

Innovation is faster through inorganic growth

One of the major reasons for companies to grow inorganically (through mergers and
acquisitions, joint ventures etc.) is to get access to the target’s innovation capabilities and
resources (Eiteman et al., 1998). Evidence shows heavy M & A activity over the last few
years and inorganic growth has become a ‘hot’ topic in the corporate environment. Small
firms rarely have capital or financial resources like that of a large multi-national firm, which
will enable them to absorb existing innovation hubs. Inorganic growth is therefore an activity
which is highly restricted for small enterprises and therefore leaves the firm with the choice
of innovating with its own resources. As discussed earlier, resource heavy industries do not
typically promote small firm innovation and innovation can be a time consuming process as
finance, labour and resources are not easily accessible especially in start up businesses.

Government Support
Innovation almost always involves a high level of risk. Although these risks may even be
greater for large firms, they are far better financially equipped and have government support
to deal with failure. Small firms rarely have an ‘insurance policy’. Even when certain

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schemes are offered by the government to promote small firm growth, these firms with their
lack of exposure to the market place may not even be aware of them simply because they are
not easily accessible (Rothwell et al, 1984). This leads to smaller firms and start-ups being
sidelined. Governments often support large firms in good times and when they are in
financial trouble. The ‘too big to fail’ (Source: http://www.ft.com/cms/s/0/4f857c8c-4a2a-
11de-8e7e-00144feabdc0.html) notion is seen to exist in developed countries (e.g. USA),
which means that the government provides heavy financial aid and support to the largest
firms around (e.g. GM, Citibank), and this can hinder smaller firms to take high risks by
trying to come up with innovations in an unforgiving market place.

Collaboration with external agencies is lacking for small firms

Research has shown that collaboration and networks of alliances can be beneficial to
innovation. The diagram below1 shows how advantageous collaboration can be for firms of
all sizes. Deakins and Freel (2003) mention the vitality of links with external parties like
suppliers, universities and other firms. Nieto and Santamaria (2006) also support the view
that collaboration can bring small firm innovation closer to the levels of their larger
counterparts. Studies have also shown that collaboration with academic institutions can add
advantage to innovative activity (Wilkinson et al. 1996).
Yet, evidence shows that small firms find it difficult to establish these external linkages and
that proves to be a constraint for innovation. The lack of external partners was found to be the
most important barrier to innovation in small firms (Hewitt-Dundas, 2006). Although there is
limited research to explain why collaborations are rare amongst small firms, possible reasons
could be:

1) Proximity to universities; remotely located firms with less number of academic institutions
around them would have to rely on their own limited resources.

2) Relationships with suppliers, dealers etc.: Being relatively unknown, small firms cannot
establish a good network amongst suppliers and dealers, which can hinder access to vital
resources and also surpass company budgets when procuring goods.

1 The OECD defines the following terms:

Inventive (formal) collaborative innovators which carry out both in-house creative activities and rely on diffusion in its
innovation activities.
Inventive (formal) non-collaborative innovators which carry out creative in-house activities, but do not actively access
external knowledge.
Informal collaborative innovators which do not carry out creative in-house activities but actively access external knowledge.
Informal non-collaborators which do not have inventive in-house activities or actively access external knowledge.

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Figure 5 (Source:
Source: OECD Microdata Project, 2008)

Conclusions and Summary

While trying to discuss the statement given, I found interesting and diverse points of view
offered by various academics regarding the small firm/ large firm debate. Although various
scholars do credit small firm innovation and take into account other parameters like
innovation rate to prove small firm superiority, in terms of sheer volume, large firms are
ahead by a considerable margin. There is clear empirical evidence
nce showing that overall, large
firms do implement innovation at greater levels than small firms do. The industries in which
small firms do innovate more than large firms are typically ones which do not require great
resources, e.g. computing, and measuring
measurin equipment. In that sense, any statement claiming
that innovation always needs a large amount of resources is false. One must keep in mind that
large firms were at one time, small. These small firms due to their innovative ability, grew at
a fast pace and are now market leaders. E.g. Apple, Dell, IBM. However, small firms face a
great set of barriers to innovation,
ion, some which have been discussed by scholars, and some
which I have discussed which are more relevant to today’s business scenario. To conclude,
although large firms have greater resources and innovate more than small firms, if
approached from a social rather than a business angle;
angle they don’t need to compete with large
firms directly. The goals and aspirations of a small firm are surely not as grand as a large one
and as discussed above, small firms outperform large ones in markets suited to them, i.e.
niche markets. Hence, the debate of small firm versus large firm innovation is somewhat
unreasonable.

References
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