Explaining Organizational Diseconomies of Scale in R&D: Agency Problems and the Allocation of Engineering Talent, Ideas, and Effort by Firm Size Explaining Organizational Diseconomies of Scale in R&D: Agency Problems and the Allocation of Engineering Talent, Ideas, and Effort by Firm Size Todd Zenger, Management Science, 1994 Group #3 Jason Franken Prasanna Karhade Hsiao-Ching Lee Jennifer Shen Marko Madunic

…in a nutshell The comparative efficiency and success of small firms in R&D is unexplained Diseconomies of scale in R&D explained by Scale diseconomies in offering employment contracts Small firms resolve agency problems more efficiently by offering performance- contingent contracts

R&D and Firm Size Large firms (Organizational Economies) Foster technological innovation efficiently Encourage efficient use of equipment, resources Encourage efficient use of specialized technical personnel Small firms (Organizational Diseconomies) Offer better contracts to attract superior talent Hire away talent from large firms Offer effort-inducing incentives

Agency Problems Hidden Information (Adverse Selection) Pre-Hire Employer unsure of employee talent Employee self-evaluation biased upward Previous employers unlikely to reveal information Post-Hire Learning that occurs on the job hidden from employers Employer unable to tap into this new knowledge Hidden Action (Moral Hazard) Observing an engineer’s behavior provides little information

Incentive Contracts and Contracting Costs Contracts as solutions to agency problems Performance-Based Argued to motivate higher effort Seniority-Based Departure penalty could motivate effort Impediments to Performance Based Contracts Measurement Costs Difficult to obtain accurate measures of ability or effort Equity Norms Encourage compensation practices that dissociate pay and performance

Firm Size and Contracting Costs Small firms, relative to large firms, will more commonly offer performance- contingent contracts either by rewarding firm performance or by differentially rewarding individual performance Small firms will attract individuals with superior talent and ideas, and will motivate higher effort than large firms

Methods Hypothesis attempting to test relationships between:- Firm size and Contractual Attributes Firm size and Individual-level Outcomes Self-selection pattern Individual skill measurements Data Questionnaire responses Personnel Records Sample Company A Relatively diverse science, engineering background Average tenure (16 years) Company B Electrical and Mechanical engineers Average Tenure (4.4 years)

Results Self-selection by Firm-Size If small firms attract superior talent, then relationships among former employees between firm size and each of the performance, skill, ability measure should be negative Employees that voluntarily depart for smaller firms posses higher ability People who depart for large firms have significantly lower scholastic achievements

Self-selection by Firm-Size Small firms may prefer high ability, highly skilled engineers with less inclination toward publishing, over similarly-skilled engineers who devote considerable attention to publishing More talented, higher performing engineers depart for smaller firms, while the less talented depart for large firms

Firm Size and Effort The results are consistent with the hypothesis that small firms motivate greater effort among engineers than large firms Higher effort among engineers is induced by small firms rather than being attracted

Compensation If performance-contingent contracts of small firms lure the superior talent from Company A and B and motivate higher effort Then, salaries in small firms must be higher than salaries in large firms Despite greater effectiveness of small firm in distinguishing and rewarding performance distinctions, the pay-performance relationship was not evident in the regressions

Firm Size and Contract Attributes The predicted size-related contract differences were more consistently evident in analyzing engineers descriptions of their employment contracts Small Firms Reward for individual performance Reward for firm performance Large Firms Substitute formal monitoring for their inability to easily observe or reward individual performance Small firm contracts involved greater risk

Alternative Hypothesis Engineers choose small firms to do independent work Results suggest that those with exceptional abilities and skill seek the independence of small firms precisely because their abilities and skills will be recognized and rewarded Firm Size Or Sub-unit Size Defining the correct subunit was problematic, hence this alternative hypothesis not tested

Implications Objective of the paper was to explore sources of organizational diseconomies of scale in R&D associated with the employment contract Although large firms can offer performance-based contracts, large firms incur considerably higher costs Firm Size and R&D This paper did not resolve the issue Provided arguments that lend support to both sides of this debate