PUBLIC GOVERNANCE, CORPORATE GOVERNANCE, AND FIRM INNOVATION: AN EXAMINATION OF STATE-OWNED ENTERPRISES

Abstract

Innovation activities create substantial firm value, but they are difficult to manage owing to agency risk, which is commonly thought to result in shirking, and hence underinvestment in innovation. However, agency risk can also create inefficient allocation of resources among innovation activities, on which the literature has provided limited understanding. We examine an important outcome created by agency risk—that agents pursue quantity of innovation at the expense of novelty—and investigate how it is influenced by corporate and public governance. We theorize that improved corporate governance tools, including better alignment of agents’ private incentives and stronger monitoring, and high-quality public governance reduce such agency risk in state-owned enterprises (SOEs). Furthermore, higher-quality public governance enhances the functioning of corporate governance tools in further reducing such agency risk in innovation. We test our theory by examining SOEs in China that responded to the state’s pro-innovation policies relying disproportionately on quantifiable outcomes (e.g., patent counts) for assessing innovation performance. Our difference-in-differences estimates provide overall support for our hypotheses. These findings provide new insights on how agency risk affects innovation by distinguishing the consequences for quantity and novelty of innovation and for how conventional corporate governance tools shaping innovation depend on public governance.