Do Higher Costs Spur Process Innovations and Managerial Incentives? Evidence from a Natural Experiment

• DOI: http://doi.org/10.1111/jems.12024
• Published date: 01 September 2013
• Author: Rajshri Jayaraman,Benoit Dostie
• Date: 01 September 2013

Do Higher Costs Spur Process Innovations and

Managerial Incentives? Evidence from a Natural

Experiment

BENOIT DOSTIE

Institute of Applied Economics

HEC Montr´

eal,

Montr´

eal Canada

benoit.dostie@hec.ca

RAJSHRI JAYARAMAN

ESMT,

Berlin Germany

rajshri.jayaraman@esmt.org

This paper asks whether firms respond to cost shocks by introducing process innovations and

increasing the use of managerial incentives. Using a large panel data set of workplaces in Canada,

our identification strategy relies on exogenous variation in costs arising from increased border

security along the 49th parallel following 9/11. Our longitudinal difference-in-differences esti-

mates indicate that firms responded to the cost shock by introducing new or improved processes,

but did not change their use of managerial incentives. These results suggest that the threat of

bankruptcy may provide impetus for improving efficiency.

1. Introduction

It is commonly thought that when faced with high costs and the threat of bankruptcy,

firms are compelled to innovate in order to reduce costs. Economists have traditionally

focused on two main mechanisms through which firms cut costs in order to reduce what

Leibenstein (1966) famously dubbed as “X-inefficiency.”1Oneis process innovation. The

other is the use of incentives, which induce managers to exert more effort. In the agency

theoretic literature these mechanisms are conceptually interchangeable, to the extent

that higher powered incentives translate into more managerial effort and both process

innovations and managerial effort reduce costs.2

In this paper,we exploit a rich nationally representative linked employer–employee

panel data set to explore the use of both of these channels at the firm level. In particular we

ask whether firms exposed to a common cost shock (as in Hart, 1983) are more likely to (i)

introduce process innovations aimed at reducing costs and (ii) offertheir managers more

performance-based incentives. We also directly examine whether managers working in

these firms exert more effort.

We thank Klaus Schmidt for many insightful discussions and two referees as well as seminar participants in

Munich, Berlin, and Naples for useful comments.

1. There are, of course, other candidates (for example, new management practices Schmitz, 2005), but

these have received considerably less attention in the theoretical agency literature.

2. Seminal theoretical contributions, which model managerial effort as a means of reducing costs can be

found in Schmidt (1997) and Raith (2003). Vives (2008) explicitly models process innovation and managerial

incentives as interchangeable instruments with which to achieve a unit cost reduction.

C2013 Wiley Periodicals, Inc.

Journal of Economics & Management Strategy, Volume22, Number 3, Fall 2013, 529–550

530 Journal of Economics & Management Strategy

In addressing these questions we make two contributions. First, although process

innovation is a seemingly natural response to adverse cost shocks, we are (to the best

of our knowledge) the first to explicitly examine whether this popular intuition finds

broad-based empirical support. The focus of this paper is therefore distinct from a large

literature on R&D responses to macroeconomic downturns on three counts (see, for

example, Barlevy, 2007 and the literature review and references therein.) First, the mea-

sures of R&D used in the empirical strand of that literature typically do not distinguish

between product and process innovation. Our data do. Second, recessions need not be

associated with cost shocks. Third, as we discuss below, our empirical strategy is predi-

cated upon filtering out the effect of economy-wide shocks on innovation—which is the

focus of that literature—in order to identify firms’ responses to cost shocks.

The second contribution of this paper is to speak to the underlying motivation

of managers by examining both innovation and managerial incentive responses to a

common cost shock within a given firm. More specifically, cost shocks to firms are

thought to motivate managers to reduce slack for two reasons. [Schmidt (1997)and

Aghion et al. (1999) provide prominent formalizations of this intuition in an agency-

and growth-theoretic framework, respectively.] First, managers bear a personal cost of

bankruptcy—at the very least, they will have to find a new job. Hence, when effort is

noncontractible, the threat of bankruptcy gives managers an intrinsic incentive to work

harder in order to innovate, reduce costs, and avert bankruptcy. Second, if profits are

reduced, a profit maximizing firm may push harder for managers to innovate by offering

them higher-powered incentives and this extrinsic incentive pay may induce managers

to work harder to reduce costs.3

We find that firms who are exposed to a common cost shock are more likely to

introduce new and improved processes relative to firms that are not exposed to this

shock. This provides direct support for the basic intuition that cost shocks induce firms

to reduce slack and improve efficiency. At the same time, firms do not alter their use of

incentive pay to managers. Because it is managers and not firms per se that introduce

process innovations, these two findings provide indirect evidence that the threat of

bankruptcy or expectations from firms that managers step up effort during times of

adversity (as opposed to explicit pay for performance) induces managers to reduce

slack. We also providesome employee-level evidence indicating that, indeed, managers

increased effort in response to the cost shock.

Endogeneity is clearly a challenge in our empirical analysis. It is likely, for ex-

ample, that a failure to introduce process innovations increases costs and the threat of

bankruptcy,or that there are common shocks, such as recessions, which impact both in-

novation and costs. Reverse causality and simultaneity of this sort would lead to bias in

our estimates. We deal with potential endogeneity by using a quasi-experiment, which

generates exogenous variation in costs facing firms.

Our data come from the Canadian Workplace and Employee Survey (WES), a rich

nationally representative panel of workplaces. The period of observation spans Septem-

ber 11, 2001. On that day, the United States locked its borders and thereafter, instituted

substantially stricter security measures at border crossings. Over 80% of the value of

Canada’s merchandise exports was transported to the United States directly across the

49th parallel via truck or rail in that year, and these new border security measures

3. Whether firms actually increase managerial incentives in responseto a cost shock is, in fact, theoretically

ambiguous. See Schmidt (1997) and Raith (2003) for two alternative theoretical treatments in the context of the

competition literature.