Explaining Organizational Diseconomies Explaining Organizational Diseconomies of Scale in R&D: Agency Problems and of Scale in R&D: Agency Problems and

the Allocation of Engineering Talent, the Allocation of Engineering Talent, Ideas, and Effort by Firm SizeIdeas, and Effort by Firm Size

Todd Zenger,Management Science, 1994Group #3

Jason FrankenJason FrankenPrasanna Prasanna Karhade Karhade Hsiao-Ching Lee Hsiao-Ching Lee Jennifer ShenJennifer ShenMarko MadunicMarko 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 efficientlyEncourage efficient use of equipment, resourcesEncourage efficient use of specialized technical personnel

Small firms (Organizational Diseconomies)Offer better contracts to attract superior talentHire away talent from large firmsOffer 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

MethodsHypothesis attempting to test relationships between:-

Firm size and Contractual AttributesFirm size and Individual-level OutcomesSelf-selection patternIndividual skill measurements

DataQuestionnaire responsesPersonnel Records

SampleCompany A

• Relatively diverse science, engineering background• Average tenure (16 years)

Company B• Electrical and Mechanical engineers• Average Tenure (4.4 years)

ResultsSelf-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 FirmsReward for individual performanceReward for firm performance

Large FirmsSubstitute 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 SizeDefining 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&DThis paper did not resolve the issueProvided arguments that lend support to both sides of this debate