Featured Research

Artificial Intelligence

HOW ARTIFICIAL INTELLIGENCE (AI) IS RESHAPING RETAILING
by Venkatesh Shankar, Texas A&M University

FUND BOARD OVERSIGHT OF ARTIFICIAL INTELLIGENCE AND QUANTITATIVE INVESTMENT 
by Brian Bruce, Hillcrest Asset Management, and Korok Ray, Texas A&M University

Autonomous Driving

DRIVERLESS ROADS
by Korok Ray, Texas A&M University

Business

EFFECTS OF ACCOUNTING CONSERVATISM ON INVESTMENT AND EFFICIENCY INNOVATION
by Korok Ray, Texas A&M University, Volker Laux, the University of Texas at Austin

In a recent paper titled “Effects of accounting conservatism on investment efficiency and innovation,” Dr. Volker Laux of the University of Texas at Austin and Dr. Korok Ray of Texas A&M University consider a key dilemma for organizations wanting to encourage innovation—how to motivate their managers to pursue innovative ideas without encouraging them to invest recklessly.

Laux and Ray’s solution brings together conservative accounting and incentive contracting to take advantage of the strengths of both. Conservative accounting refers to accounting rules and regulations that have stringent conditions for awarding favorable earnings reports. Managers working in a conservative accounting environment cannot exaggerate their performance and are only recognized for exceptionally positive work. Because of this this, the managers practice caution and prudence. One desirable quality of conservative accounting is that it is highly accurate—a positive report typically reflects genuinely positive performance.

It is commonly held that conservative accounting practices value risk avoidance and therefore inhibit innovation. However, Laux and Ray point out that by using one of the many tools at an organization’s disposal—incentive contracts—organizations can take advantage of the accurate reports produced by conservative accounting to better link a manager’s compensation to their performance. Under this model, managers are incentivized to pursue productive innovations but are not willing to overinvest in risky innovations. This, in turn, improves investment efficiency, increases the organization’s value, and encourages innovation.

CAN CORPORATE INCOME TAX CUTS STIMULATE INNOVATION?
by Julian Atanassov, University of Nebraska, and Xiaoding Liu, Texas A&M University

The impact of corporate taxes on economic growth has long been a source of debate among politicians and policy makers. Although much of the current literature on taxes analyzes only short-term effects, in a recently published paper, Dr. Julian Atanassov of the University of Nebraska and Dr. Xiaoding Liu of Texas A&M University contribute to the discussion by drawing a clear connection between corporate income tax cuts and increased innovation. Additionally, Atanassov and Liu describe some of the mechanisms by which taxes relate to innovation, and consequently, to long-term economic growth.

Atanassov and Liu’s research supports the view that corporate income tax cuts improve companies’ incentives to innovate by increasing their pledgeable income. To establish causality, they use staggered changes in state corporate income tax rates from 1988 to 2006 that are largely exogenous to the decisions of the individual firm to innovate. Using a sample of around 8,000 publicly traded US firms and a differences-in-differences methodology, Atanassov and Liu empirically document that tax cuts significantly increase both the number of patents and the number of citations per patent—common measures of innovation—three and four years after the tax cut. They also find a similar but opposite effect for tax increases.

Atanassov and Liu then explore the mechanisms through which corporate income tax cuts affect innovation. Their model shows that pledgeable income depends on firms’ after-tax profits as well as on the size of the private benefits of control and the assets at hand. Consistent with their model predictions, they first find that tax cuts have a greater impact on financially constrained companies. They show similar results for companies with fewer tangible assets or smaller patent stock. Next, they find that tax cuts have a greater impact on companies with weaker corporate governance, where managers are monitored less and are less incentivized to take on innovative projects.

Finally, Atanassov and Liu analyze the efforts of companies to minimize their tax burdens and find that the impact of tax cuts on innovation is greater for firms that engage in tax avoidance. They assert that companies practicing tax avoidance are able to shift resources to innovation after significant tax cuts.

Atanassov and Liu’s work contributes to several ongoing discussions on how taxes impact R&D, innovation, and long-term economic growth. Furthermore, they describe several mechanisms that explain how tax cuts lead to corporate innovation, which have substantial implications for policy making and future research.

INNOVATION SEARCH STRATEGY AND PREDICTABLE RETURNS
by Tristan Fitzgerald, Texas A&M University, Benjamin Balsmeier, University of Luxembourg, Lee Fleming, University of California, Berkeley and Gustavo Manso, University of California, Berkeley

In a recent paper entitled “Innovation Search Strategy and Predictable Returns,” Tristan Fitzgerald of Texas A&M University, Benjamin Balsmeier of the University of Luxembourg and ETH Zurich, Lee Fleming of the University of California, Berkeley, and Gustavo Manso of the University of California, Berkeley, examine how accurately stock market investors value different innovation strategies. In particular, the authors investigate how investors respond to two types of innovation strategies that companies can pursue: exploitative innovation, which focuses on refining and expanding existing areas of knowledge, and explorative innovation, which focuses on discovering novel technologies that are further from the company’s existing areas of knowledge.

The authors use two metrics to measure a company’s innovation search strategy: internal search proximity (a new indicator that measures the amount of overlap in the technology classes of a company’s new and existing patents) and the exploitative patent ratio (which focuses on the amount of new knowledge sources used in a company’s recent patents). The authors first find that companies focusing on exploitative innovation tend to generate better future operating performance compared to companies focused on explorative innovation. Interestingly, companies focused on exploitative innovation tend to significantly outperform the market’s near-term earnings expectations, indicating that the market does not fully take the economic value generated by exploitative patents into account. These findings reveal how certain innovative companies may be systematically undervalued by the market.

Similarly, companies focused on exploitative innovation also tend to be undervalued in predictions of future stock returns relative to companies with exploration-focused search strategies. Importantly, this return differential is distinct from and incremental to standard risk, mispricing, and innovation-based pricing factors examined in the prior research.

The authors find that the undervaluation of exploitation-focused companies is strongest at firms with inattentive investors. This conclusion is consistent with much of what the psychology and neuroscience literature has already concluded: Humans are drawn to novelty. Inattentive or time-constrained investors seem to view explorative innovations as rare and remarkable and thus pay more attention to understanding these breakthrough discoveries. In contrast, investors devote insufficient time and resources to understanding the value of more incremental and ordinary exploitative innovations. Companies seem to exacerbate these investor biases by publicizing their explorative innovations more; explorative innovations build a company’s reputation and attract more attention. It appears that many inaccurate return predictions for exploitation-focused companies are driven by investors and equity analysts failing to fully understand the significant profits generated by exploitative innovation.

These findings have important implications for corporate innovation research and financial markets. The authors’ results imply that managers may need to change how they fund their R&D operations and emphasize the need for companies to educate their investors about the positive earnings impact of exploitative patents, especially in the short and medium term. The paper’s results also challenge the widely held view that the pressures of the stock market hamper innovation. In particular, the authors’ findings suggest that reality is more nuanced; the stock market’s effect on innovation depends on the type of innovation pursued. The insights provided by this research emphasize the need for companies to recognize biases toward exploratory innovation in order to maximize corporate innovation and operating performance.

LOST IN A UNIVERSE OF MARKETS: TOWARD A THEORY OF MARKET SCOPING FOR EARLY STAGE TECHNOLOGIES
by Sven Molner, University of London, Jaideep C. Prabhu, University of Cambridge, and Manjit S. Yadav, Texas A&M University

THE RELATIVE EFFECTS OF BUSINESS-TO-BUSINESS (VS. BUSINESS-TO-CONSUMER) SERVICE INNOVATIONS ON FIRM VALUE AND FIRM RISK: AN EMPIRICAL ANALYSIS
by Thomas Dotzel, University of Nebraska, Venkatesh Shankar, Texas A&M University

ASSESSING THE GAINS FROM E-COMMERCE
by Paul Dolfen, Stanford University, Liran Einav, Stanford and NBER, Peter J. Klenow, Stanford and NBER, Benjamin Klopack, Stanford, Jonathan D. Levin, Stanford and NBER, Larry Levin, Visa, Inc., Wayne Best, Visa, Inc.