Innovation, Governance and Competition

We consider a two period career concern model where corporate governance is a decisive factor for innovation efforts by a manager. In the beginning of the frst period, a manager decides whether to innovate. Prior to the innovation decision, the ability of the manager is unknown to the firm but known to the manager and an expected wage is paid based on a probability distribution of managerial abilities. The success of the innovation is both a function of the managerial ability and the product market competition and the beliefs about the managerial ability is updated if the manager innovates and the wage is set for the second period accordingly. Our model predicts that the rate of innovation would be higher under a more democratic governance structure and relatively low product market competition. Using a panel dataset from 1990s, compiled from Aghion et al.(2013b) and Gompers, Ishii,and Metrick (2003), containing time-varying information of patent citations, R&D, product market competition, and Governance index, we show that there is a robust association between innovation and the quality of governance and this relationship is strongest in industries with relatively low competition.