Innovation, Intellectual Property and China

By Josh Lerner

Posted on July 12, 2019


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Image: Josh LernerDoes the Chinese economic miracle undermine the idea that institutions are essential to protect innovation and encourage growth? Josh Lerner is the Jacob H. Schiff Professor of Investment Banking at Harvard Business School and a leading expert on innovation policies and their impact on firm strategies. Here, he presents his recent research on intellectual property rights and innovation in China.

 

Harkening back to Schumpeter, the literature on law and finance argues that effective legal and financial institutions lead to better economic outcomes (see panel at end of article). But China’s rapid economic growth in the past 30 years raises questions about this view. As Allan, Qian, and Qian (2005) point out, China has achieved the fastest sustained growth in history despite having poor legal and financial institutions. Instead, the economic development model China has followed in the past 30 years relies on a strong state sector, with many state-owned enterprises and strong government direction. This experience suggests that, at least in the case of China, good institutions may not be necessary for economic development, and poses profound questions for academics and policymakers alike.

 

The Chinese Puzzle

 

In an ongoing line of research, Lily Fang, Chaopeng Wu, and myself examine these big questions by focusing on innovation, an activity that Schumpeter identified as critical to economic change. In this summary, I will highlight our work on intellectual property right (IPR) protection and innovation in China. In a paper co-authored with Lily Fang and Chaopeng Wu, ‘Intellectual property rights protection, ownership, and innovation: Evidence from China’ (2017, Review of Financial Studies), we shed light on the following three questions:

 

1. Where has China’s innovation taken place: in state-owned enterprises (SOEs) or in private-sector firms?
2. Are legal institutions - in particular, IPR protection - important for innovation within China?
3. If so, are SOEs or private sector firms more sensitive to IPR protection?

 

China’s ability to innovate is not only an interesting and relevant question for economists, but also a timely matter of first-order policy importance to the Chinese. Since China’s economic reforms started in the late 1970s, the country’s growth has largely relied on cheap labor and state-led investments in physical infrastructure. But as China’s labor costs have surged and growth rates have declined in recent years, this growth model has been widely seen as obsolete. China’s top leaders are promoting innovation as the key to the country’s sustained economic growth: for instance, in the 13th Five-Year Plan released in March 2016, innovation was listed as the first guiding principle of economic policy. But the extent to which the state can drive innovation without sound institutions and economic incentives remains in question.

 

Was Schumpeter Right?

 

There are two competing hypotheses about where innovation is likely to take place and the importance of IPR protection in China. Entrepreneurs’ incentives to innovate - what Schumpeter terms the “entrepreneurial spirit” - depend on their ability to capture the profit from innovation, which in turn depends on IPR protection and institutions such as the patent system. The danger of ex post expropriation as a result of poor IPR protection will deter innovation, consistent with classic arguments by Ken Arrow (‘Economic welfare and the allocation of resources for invention’ in The Rate and Discretion of Inventive Activity, edited by R. Nelson, 1962). This line of reasoning concludes that, in China, precisely because private firms face a high risk of expropriation, institutional quality such as IPR protection standards should be particularly important for innovation in the private sector. We call this the “Schumpeterian view”.

 

On the other hand, despite the country’s poor record of IPR protection, China has in recent years become the most prolific patent-filing country in the world (see Figure 1). One explanation for this paradox is that in the absence of legal protection, state ownership acts as an alternative mechanism, giving state-owned firms both incentives (or directives) for innovation and protection against expropriation. SOEs in China, in fact, have a two-tiered defense against expropriation: through administrative measures by the government (the firms’ owners), and through the courts, which are often biased in their favor. This explanation suggests that China’s innovation should be led by the SOEs, and because they rely on the state, institutions such as IPR protection do not matter much. We call this the “alternative mechanisms view”.

 
Image: Graph of worldwide patents
 

Empirical Challenges

 

To test these hypotheses, we compare the firm-level innovation (based on patent activity) of SOEs and private firms across Chinese cities with varying levels of IPR protection. We do not, however, undertake a simple cross-sectional comparison, because doing so raises two concerns. First, SOEs and private firms are inherently different: their geographic and industry distribution is non-random and may be related to the quality of local IPR protection. Second, even the quality of local IPR protection itself can be a consequence of local innovative activities (and hence demand for IPR protection), rather than having a causal effect on innovation.

 

To address these empirical challenges, we exploit China’s privatizations of SOEs. The idea is that the privatization events result in a sharp change in the firms’ ownership structures and state affiliations, while keeping other firm attributes fixed. We can therefore compare the rates of innovation before and after the change in ownership within the same firm. By studying this before-and-after difference in innovation rates across firms in regions with varying local IPR protection standards, we can identify the joint effect of ownership type and IPR protection. In essence, these events allow us to use a difference-in-difference method.

 

Our approach would be problematic, however, if innovative firms and entrepreneurs felt shackled by state ownership and initiated privatizations precisely in order to engage in more innovation.

 

Fortunately, this concern is allayed by China’s political economic history. SOE privatizations and restructurings were key policy initiatives of China’s top leaders from 1996 to 2005 (the 10-year period covering the 9th and 10th Five-Year Plans). This policy drive led to a massive and sweeping privatization wave, which by some estimates ultimately privatized two-thirds of the state sector. The overarching goal of these privatizations was to increase the efficiency of China’s vast state sector and to transition the country from central planning to a market orientation. In contrast, innovation became a policy focus quite recently.

 

Key Results

 

We document three main findings. First, innovation increases significantly after firms are privatized. On average, firms’ patent stock increases by 200% to 300% in the five years after privatization compared to the five years before. Second, the increase in innovation is significantly larger in cities with high IPR protection than in cities with low IPR protection. A one standard-deviation increase in local IPR protection score nearly quadruples the post-privatization increase in patent stock. Third, we find evidence that patents of private-sector firms are cited more often and have a greater international presence -in other words, are of higher quality- than patents of SOEs, suggesting that the increase in patent filings is not a consequence of “window dressing”. In sum, our evidence is strongly supportive of the Schumpeterian view that institutions matter, even in China. It is inconsistent with the alternative mechanisms view delineated above.

 

In short, China’s spectacular growth poses many puzzles to the economists. We hope that this work - as well as our follow-on work on subsidies for innovation in China (see panel) - will shed light on some of these.

 

Panel

Image: Panel

 

 

The preceding is republished on TAP with permission by its author, Professor Josh Lerner, and by the Toulouse Network for Information Technology (TNIT). “Innovation, Intellectual Property and China” was originally published in TNIT’s June 2019 newsletter.

 


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