Innovation and foreign ownership

or why foreign ownership isn't bad. Studies have shown that foreign-owned firms are typically more productive. A new column from VoxEU.org presents evidence from Spain that suggests this is mainly due to foreign firms buying the most productive domestic companies.

In their column Maria Guadalupe, Olga Kuzmina and Catherine Thomas ask whether foreign owned firms superior productivity is due to Improvement or selection? That is, they ask Does the observed productivity advantage of the subsidiaries of foreign owned firms reflect improvements due to the multinational companies (MNCs) or acquisition by MNCs of the most productive domestic performers? They write,

Data from Spanish manufacturing firms reveal that up to two-thirds of the performance premium associated with multinational control is due to the fact that multinational firms acquire domestic firms that were initially more productive. The remaining one-third is due to changes made within the subsidiary after acquisition. Specifically, we show that acquired firms undertake more process innovation – simultaneously investing in new machinery and adopting new organisational practices.

We ask why multinationals acquire the best firms, and why these firms subsequently undertake more innovation once they are under multinational control. We find that the optimal amount of innovation is larger when an acquired firm is more productive to start with, because the benefits associated with technology upgrading are proportional to initial firm productivity.

We then show how these benefits are further amplified when the acquired firm accesses export markets through its multinational parent. Empirically, we find evidence for this mechanism. The extent of technology upgrading is significant in firms that use the foreign parent to increase their exports. Taken together, these results suggest that the multinational advantage that results from acquisition is not necessarily due to a transfer of technology from a sophisticated parent firm with lower costs of innovating to a newly acquired subsidiary. It can come about because acquired firms that are part of multinationals gain access to integrated global product markets, even when all firms have the same costs of innovating.

But what is the mechanism explaining both acquisition patterns and technology upgrading.

The mechanism explaining both acquisition patterns and innovation after acquisition relies on the simple assumption that a firm chooses to invest to upgrade its technology as long as the marginal benefits to the firm – in terms of future production profits – exceed the marginal cost of technology investment. The key insight of our paper is that the ownership structure can lower the costs of investment in technology, for example, because a foreign parent firm has proprietary production processes, but can also affect the benefits of technology investment. If the parent firm has large-scale sales and marketing operations, perhaps in other countries, then this may increase the incremental profit from technology upgrading since it increases the average per-unit production profit for a larger volume of sales. In either case, a firm will make more profits from a given improvement in technology under foreign ownership, and will also choose to upgrade technology to a higher level. The additional value created by any technology upgrade is positively related to the initial productivity of the firm. This means that the value-added of foreign ownership relative to domestic control is increasing in initial productivity and, hence, multinationals will opt to acquire the best-performing domestic firms in an economy.

The implications of this?

What are the implications of the findings for the evolution of the distribution of productivity within industries? Our key result is that foreign firms are more likely to acquire the most productive firms within industries, and acquired firms start to innovate more on acquisition.

Taken together this implies that acquisition activity can lead to an increase in the dispersion of the productivity distribution.

Under this mechanism, foreign entry does not lead to productivity convergence, but, on the contrary, could lead to further divergence. Of course, there could be other reasons (such as spillover effects or other externalities) why multinational entry may improve less productive firms’ productivity, and their entry could drive out of business the least productive firms, thus increasing the minimum level of productivity in the industry. However, the direct effect of the foreign acquisition process is an increase in productivity heterogeneity.
A novel result in the paper is to show that an important underlying reason for this divergence in productivity in the Spanish data is not just that the newly acquired firms may have access to superior technologies, but that technology upgrading is also significantly related to firms’ differential access to new export markets.

One important policy implication of the findings, then, is that other channels that reduce the fixed cost of export-market access and open up markets for domestic-controlled firms could lead to some of the productivity improvements documented in foreign-acquired Spanish manufacturing firms.