Impact of technology sourcing strategies in Chinese firms

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  • 2012•01•12

    Jun Hou and Pierre Mohnen

    A recent UNU-MERIT working paper explores the impact of internal and external technology sourcing on innovation and productivity performance in Chinese small and medium-size manufacturing firms. In particular, it investigates whether a complementary relationship exists between the two, and concludes that while each contributes significantly to product innovation, there is no sign of synergy in raising productivity.

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    In order to catch up with the technological frontier, firms in developing countries strive to advance technologically through internal research and development efforts (in-house R&D) as well as through external technology purchasing (TP). In-house R&D expenditure includes the capital, labour and design costs associated with research and development, while TP involves purchasing, transferring or licensing new technologies from the domestic or the international market. Establishing efficient innovation strategies helps firms to catch up quicker and contributes to their economic development.

    In China, the central government has instituted a series of policy incentives to encourage in-house R&D that have greatly increased the country’s capability to develop its own technology and to assimilate and improve upon technology transferred from advanced economies (Lu and Lazonick, 2001). However, because of shortcomings inherited from the pre-reform planned economic mechanism, the efficiency of innovation in the manufacturing sector in China is still severely constrained.

    With great emphasis placed on “indigenous innovation” (the ability to conduct R&D or create innovation internally), do Chinese firms still need external technology sourcing? Is there a synergy in engaging in both internal and external innovation activities? The goal of our recent paper (available to download in the sidebar on the right) was to answer these questions via an empirical framework allowing us to investigate the role of these innovation input strategies in fostering productivity in Chinese manufacturing firms.

    Relationship between sourcing strategies

    A growing number of empirical studies are estimating the relationship between innovation sourcing strategies in developing countries. One view is that internal R&D and external technology are substitutes. Firms decide to produce their own technology and/or buy it from outside, dependent on a given budget. An increase in either of the two choices, therefore, tends to lower the spending on the other.

    An alternative view is that in-house R&D and external technology purchasing are complementary strategies. Based on the notion of absorptive capacity proposed by Cohen and Levinthal (1989), it is argued (Fu, Pietrobelli and Soete, 2010), that a crucial condition to obtaining effective technology transfer for developing countries is their level of absorptive capacity. Other studies confirm this view that technological capability is needed in order to understand the tacit components of foreign technology.

    On the other hand, acquiring technology externally helps improve the efficiency of doing in-house R&D. As Aggarwal (2000) points out, external technology sourcing plays two important roles in developing economies: filling gaps in domestic technological capability and upgrading the existing technologies to international standards.

    China has been the fastest growing major economy in the past 30 years with an average annual GDP growth rate of over 10%. Around 8 % of the world’s total manufacturing output comes from China, and the nation ranks third worldwide in industrial output. This makes it very interesting to study the country’s technology acquisition behaviour and to examine whether it contributed to the growth performance of its manufacturing firms.

    In the 1950s, China began to acquire technology externally. At first, the major source was the former Soviet Union. Then, Western countries and Japan became the main technology suppliers in heavy industry. After the economic open-door policy was launched in 1976, importing external technology constituted an essential component of the Four Modernization Programmes (Zhao, 1995). Technology transfer became diversified and the sources widened. After the 1980s, still other industrial countries and regions played an increasing role. Meanwhile, the central government created incentives and provided support for firms to establish R&D departments, greatly improving China’s indigenous innovative capability to develop and utilize technology (Lu and Lazonick, 2001).

    Analysis in terms of two measures of performance

    Like other developing countries, China has two main objectives in acquiring foreign technology: enhancing technological capability and facilitating economic growth by increasing productivity. In our research we looked at the innovation sourcing strategies of small and medium-size Chinese manufacturing firms in the 2000–2002 period. (Small firms are those having fewer than 500 employees; medium-size firms have between 500 and 2,000 employees; this is based on the number of long-term employees according to “the classification of small, medium and large Chinese manufacturing firms” from the National Bureau of Statistics of China.)

    What distinguishes our study from previous studies is the analysis of the complementarity between internal and external knowledge sourcing in terms of two measures of performance: innovation output and total factor productivity.

    A pair of economic activities is complementary if (i) adopting one does not preclude adopting the other one and if (ii), whenever it is possible to implement each activity separately, the sum of the benefits to do just one or the other is not greater than the benefit of doing both together.

    The data used in our empirical analysis are from the World Bank Investment Climate Surveys  — China 2003. The survey was conducted in 24 industrial cities and provides a wide range of information about the economic environment and activities of the firms.

    There are two categories of variables that might affect the probability of successful innovation. The first category captures firm specifics. With more profits in previous periods, firms have more cash on hand and are therefore more likely to invest in innovation and be successful innovators (Katrak, 1997).  The second category of explanatory variables is the set of innovation inputs.

    Our econometric analysis focused on how innovation strategies affect firms’ innovation and productivity performances.  We first look at the determinants of firms’ innovation output and test the complementarity between R&D and TP by estimating the interaction term in the innovation propensity. As expected, firms with higher profit tend to be more innovative. Any kind of cooperation activity will also encourage firms to become more innovative. Cooperation with universities and research institutes increase the propensity of innovation by 18% and 14%, respectively. State-owned enterprises (SOEs) are 12% more likely to innovate compared to other firms — possibly because SOEs find it relatively easier to take advantage of financial and policy support from the central government.

    Turning to the primary interest of this research, we find complementarity between R&D and TP in making firms innovative: the estimated coefficient for R&D*TP is positive and significant. Investing 100 RMB more per person in R&D increases the probability of innovating by 0.6% in the absence of technology purchasing. The marginal effect of technology purchasing is not significant; increasing R&D by 100 RMB per person when the technology purchasing is at the sample mean value of 450 RMB per person increases the probability of innovating by just 1.3%. Furthermore, profitability and R&D cooperation with research institutes tend to increase the propensity of product innovation only (not of process innovation).

    On the other hand, exporting firms have a higher probability to have process innovation, but not product innovation. State ownership and other R&D cooperation activities encourage both product and process innovation. In-house R&D is critical in stimulating innovation in both product and process innovation, but TP does not appear significant in either one. Any complementary effect between R&D and TP is confined to product (not process) innovation.

    Our result may seem to contradict those obtained by Bönte (2003) and Belderbos et al. (2008), who concluded that there was complementarity between internal and external (i.e., contracted-out) R&D in West -Germany and the Netherlands, respectively. However, firstly, our measure of purchased technology relates to the purchase of existing technology, from domestic or foreign sources and not to the execution of R&D outside of the firm’s R&D facilities. We did not investigate the complementarity between ways of performing R&D but between R&D and the purchase of existing technology. Secondly, we examined firm data from a developing country and not from developed countries. It may well be that small and medium-size firms in China do not have sufficient absorptive capacity to benefit from a synergy between own research and purchased technology. Our results are more comparable and in line with those reported by Fikkert (1993) and Basant and Fikkert (1996).


    In summary, R&D is found to contribute significantly to the occurrence of product or process innovation, whereas technology purchasing has no significant direct effect on the two measures of innovation output and affects the creation of new products and processes only by raising the knowledge acquired from internal R&D. The two technology acquisition strategies are complementary in making firms innovative, but when innovation is split into product and process innovation, complementarity only shows up in product innovation. When it comes to explaining labor productivity, technology purchases yield higher returns than internal R&D efforts in Chinese small- and medium-sized manufacturing enterprises. There is no sign of complementarity between internal and outside knowledge acquisition in fostering labor productivity.

    Our results suggest that Chinese government policies should stimulate both in-house R&D and external technology-purchasing activities. One reason we may not find any complementarity between in-house R&D and technology purchasing is that there is insufficient absorptive capacity in Chinese small and medium-sized manufacturing firms. Besides the need for acquiring and transferring new technologies from outside, it is crucial for these firms to raise their indigenous innovation capabilities so as to reap positive returns from outside technology adoption.