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16374Patent Premium in China: The Moderating Role of Institutions and OwnershipAbstractThe weak intellectual property rights (IPR) protection in emerging economies poses a critical challenge for firms to appropriate returns from their innovations. In this study, we investigate whether and when firms in emerging economies, in particular in China, can obtain patent premium, which is defined as the incremental returns from firms patent in addition to the value of the unpatented invention. Drawing on institution-based view in the context of international business, we hypothesize on how firm ownership and institutional development collectively affect patent premium. Empirical analysis demonstrates that high-tech firms in China obtain patent premium despite of the weak IPR protection in the country. The magnitude of the patent premium varies between foreign and domestic firms, and between state-owned and privately-owned firms. We also find that institutional development has disparate effects on patent premium across firm ownership types.Keywords: Patent premium, intellectual property rights, innovation, institutional development, ownership1. IntroductionThe last decade has witnessed a surge of innovation activities in emerging economies (Qu et al., 2013, Zhao, 2006, Thursby and Thursby, 2006). However, the weak intellectual property rights (IPR) protection in emerging economies poses a critical challenge for firms to appropriate returns from the innovations (Nandkumar and Srikanth, 2015). The appropriation literature asserts that patenting may not be viable in countries where law enforcement for IPR is weak (Al-Aali and Teece, 2013) because the effectiveness of patenting primarily depend on quality of the national laws and institutional environment in which firms operate (Schankerman, 1998, Somaya, 2012). In such cases, innovators must count on other appropriation mechanisms, such as secrecy, the ownership of complementary assets or the advantage of lead time (“first to market”) to capture value from innovations (Al-Aali and Teece, 2013). Nevertheless, patent applications in emerging economies, most notably in China, have been growing steadily in the recent decades (Li, 2012, Keupp et al., 2012). Patent statistics reveals that the number of invention patent applications received by the State Intellectual Property Office of China (SIPO) increased from 63,000 in 2001 to 1.3 million in 2016, producing a staggering 21-fold growth. Domestic and foreign applications for invention patents have both been growing at an annual average rate of 21% in the period of 1986-2015 (Hu and Jefferson, 2009, Hu, 2010). China surpassed the US in 2011 to become the country receiving the most invention patent applications in the world.This phenomenon is striking considering the weak institutional environment and IPR protection in China (Zhao, 2006, Li, 2012), which presumably lead to weak incentives to patent (Hu and Jefferson, 2009). The paradox has prompted researchers to investigate the conditions that are motivating the rapid growth of patenting in China (Li, 2012, Hu and Jefferson, 2009, Hu, 2010, Keupp et al., 2012). These studies point to two main conclusions: first, that a number of forces have contributed to the patent surge in China, but foreign and domestic firms patenting decisions are driven by disparate factors, and second, that despite the divergent motivations to patent, foreign and domestic firms both consider institutional environment (legal development such as patent law amendments and government intervention such as government subsidy) an important factor. Despite the fruitful literature on why firms patent in China, the questions of whether and when patents are valuable for firms in an emerging economy with weak IPR protection have received less attention.Combining insight gained from the extant literature of patenting surge in China with institution-based view in the context of international business, this study aims at understanding how patenting can be valuable for firms in an emerging economy. We denote the value of patents by patent premium, which refers to the incremental returns produced by the patents in addition to the value of the unpatented inventions (Arora et al., 2008)Arora, 2008, R&D and the Patent Premium;Arora, 2008, R&D and the Patent PremiumArora, 2008, R&D and the Patent Premium;Jensen, 2011, Estimating the patent premium: Evidence from the Australian Inventor Survey. We propose that institutional development and firm ownership, whether it is foreign or domestic and whether it is state-owned or privately-owned, collectively affect a firms patent premium, and firm ownership moderates the effects of institutional development on the firms patent premium.The ideal method to estimate patent premium is to compare the value of a patented invention with and without the patent (Gambardella, 2013), but the counterfactual, i.e. the value of a patented invention had it not been patented, is hard to observe. In this paper, we adopt a bias-corrected matching approach using a large dataset, which is compiled by matching the data from the Chinese National Bureau of Statistics Annual Survey of Industrial Enterprises with the patent data from SIPO. Besides firm-level patenting information, the data include key firm-level financial information such as sales, capital investment, and employment, as well as demographic information such as founding year and ownership details. A nearest-neighbor matching estimator is used to find the counterfactual firms, which did not start patenting in the observational period, closest to the firms that started patenting in the observational period, and then to compare their performance. If there is significant difference between the performance of the two types of firms, it would be due to patenting. This difference is the key to our empirical identification of the patent premium.This study makes several contributions. From a theoretical standpoint, this study advances our understanding of appropriation strategy by drawing on institution-based view in the context of international business and extending the literature to an emerging economy setting. Conventional wisdom about appropriation in emerging economies argues that patenting is inadequate and alternative mechanisms should be adopted (Zhao, 2006, Keupp et al., 2009, Li, 2012). Contrary to that, our findings imply that patenting can be a valid appropriation mechanism and patents can be quite valuable in an emerging economy, because firms there can employ relationship-based strategies and social connections to make up for institutional voids. This study is the first to empirically estimate the patent premium in an emerging economy. We find a significantly positive patent premium in China. However, the benefit of patenting in China may not be equally distributed across firms of different ownership types, as firms with different ownership are with diverse capabilities, resources, and adopt different strategies to capture returns from patenting. We find that domestic firms obtained higher patent premium than foreign firms. This finding diverges from extant literature in the setting of a developed economy, which demonstrate that patents owned by foreign firms are typically more valuable than patents owned by domestic firms (Pakes et al., 1989, Lanjouw, 1992, Putnam, 1996). There is mixed evidence in Schankerman (1998)s study. This study also contributes to the literature by theorizing institutional development can exert differential impact on the value of patent that firms can capture, as the firms with diverse ownership benefit differently from institutional development. We find that the magnitude of patent premium obtained by domestic firms, in particular privately-owned firms, is higher when the quality of institutions is low. In contrast, foreign firms patent premium is statistically insignificant when the quality of institutions is low and turns positive only when the quality of institutions is high. The remainder of the paper is organized as follows. Section 2 reviews the means of patent premium generation. Section 3 draws on institution theory in the context of international business and develops hypotheses. Section 4 describes the data sources and empirical strategies. Section 5 shows the empirical analyses and results. Section 6 concludes with a discussion of the implications of our findings.2. Means of Patent Premium Generation There is a variety of means of extracting value from patent right (Al-Aali and Teece, 2013, Shapiro and Varian, 1998, Arora and Ceccagnoli, 2006, Fisher Iii and Oberholzer-Gee, 2013, Hsu and Ziedonis, 2013)Hsu, 2013, Resources as dual sources of advantage: Implications for valuing entrepreneurialfirm patents;Fisher Iii, 2013, Strategic Management of Intellectual Property: An Integrated ApproachFisher Iii, 2013, Strategic Management of Intellectual Property: An Integrated Approach;Hsu, 2013, Resources as dual sources of advantage: Implications for valuing entrepreneurialfirm patents. Patenting has long been recognized in management research as an isolating mechanism, which provides owners the right to exclude others from using the invention for a limited period (Ziedonis, 2004, Mansfield, 1986). The exclusionary power of patent rights is part of market power (Bessen, 2009) and allow firms to pursue additional profit opportunities and competitive advantage (Somaya, 2012, Gambardella, 2013). A firm holding patent rights can exercise the market power by raising the prices it charges for its own products or services above the level at which they would charge in a competitive market (Fisher Iii and Oberholzer-Gee, 2013). Another approach to exercise market power is through enforcement of patent rights, which entails use or threatened use of litigation to stop infringers from using patented inventions (Somaya, 2012). Exercising market power is by no means the only option available. Going beyond the scope of a single patent, firms can also develop a carefully crafted portfolio of related patents to impede imitation, deter competition, and defend against patent infringement suits (Whittington et al., 2009, Reitzig, 2004, Fisher Iii and Oberholzer-Gee, 2013). In many contexts, a large patent portfolio is also used as a bargaining chip in cross-licensing negotiations (Reitzig, 2004), in which each party in the cross-licensing settlement receives a license to use the others technology to make its own products (Al-Aali and Teece, 2013).An additional means of patent premium generation is licensing or selling patent rights. These transactions can be beneficial or even bring strategic advantage for patent owner (Somaya, 2012, Fisher Iii and Oberholzer-Gee, 2013). For instance, licensing patent rights can discourage imitation and reduce rivals incentives to challenge the validity of patent rights (Fisher Iii and Oberholzer-Gee, 2013). Carefully calibrated licensing or selling patent rights might help patent owner to increase capacity, augment the demand for its products, and shape competition (Fisher Iii and Oberholzer-Gee, 2013). A firm can further enhance the value of its patent rights through technological collaboration. A salient example is standard setting, in which a firm negotiate with competitors for creating a technology standard in its favor if it owns key enabling patents for the standard (Shapiro and Varian, 1998). When a firms patents are included in a technology standard, these patents are more likely to be licensed (Joshi and Nerkar, 2011). Moreover, the inclusion of patents in standards-based patent pools can increase subsequent innovation that builds on them (Rysman and Simcoe, 2008), which may propel the patented technologies toward becoming a dominant design in the industry (Somaya, 2012). When a product is designed and manufactured following the dominant design and common technology standards, the value of the product to consumers often sharply increase (Fisher Iii and Oberholzer-Gee, 2013), which in turn facilitate the firm to profit from the patented technologies (Teece, 1986) The various approaches of patent premium generation are summarized in Figure 1. None of these activities is optimal under all circumstances though (Fisher Iii and Oberholzer-Gee, 2013). Firms can effectively increase the appropriability afforded by their patents via undertaking these activities in a concerted and coordinated manner (Somaya, 2012). -Insert Figure 1 about here-3. Hypothesis DevelopmentUnlike a developed economy, an emerging economy is characterized by weak institutional environment, lack of transparency of laws or their inadequate enforcement, and weak protection of IPR (Ostergard, 2000, Oxley, 1999). The “institutional voids” (Khanna and Palepu, 2013) that prevail in emerging economies make it difficult to appropriate returns from innovation through patent protection (Teece, 1986, Al-Aali and Teece, 2013, Schankerman, 1998). Thus, the value of patents as an appropriation mechanism might diminish in an emerging economy. To make up for the “institutional voids” and exploit the opportunities arising from the underdeveloped institutions, firms in emerging economies usually employ a relationship-based strategy (Peng, 2003). For high-technology companies trying to appropriate returns from their innovation, the most important relationships for them to build would be with government authorities, legal experts and technology stakeholders such as technology buyers and partners in technology alliances. The links with government authorities can be a highly efficient and cost-effective strategy for firms to protect against unwitting patent infringement. For instance, by hosting professional workshops and seminars open to local government officials, firms may gain better recognition and are more likely to be regarded as deserving IPR protection in case of patent infringements (Keupp et al., 2009). In patent litigations, firms can engage in strategies and tactics to gain a favor of government agencies or courts in terms of patent enforcement (Somaya, 2012). In addition to the legal route, patent rights in China can be enforced through the administrative channel. Good relationships with administrative staffs in government agencies such as Chinese customs can make these staffs act immediately against IPR infringements without lengthy or uncertain court trials (Keupp et al., 2009). Legal experts play critical roles in patent enforcement. Close ties with them provide firms reliable access to important legal, political or locality-specific knowledge and resources in patent litigations. Legal experts also serve as crucial intermediaries in patent transactions such as licensing, selling and cross-licensing of patents. In emerging economies, acute information asymmetry between transaction parties and lack of contract enforcing mechanisms often drives up the transaction costs in conducting these activities (Yiu et al., 2007, Khanna and Palepu, 1997, Meyer, 2001). Firms that are well connected with legal intermediaries and other firms in the industry may have access to reliable information about potential licensees, buyers and cross-licensing partners for their patents, and may be more effective in enforcing contract in patent transaction. These relational advantages can minimize their transaction costs and facilitate patent premium generation. Overall, these relationship-based strategies and the social connections that are built with government authorities, legal experts and other organizations help firms compensate for the institutional voids common in emerging economies (Peng and Heath, 1996). Although weak institutions in an emerging economy may dampen the appropriation of returns from technological innovations and accordingly the magnitude of patent premium, these relationship-based strategies can help firms mitigate the risk resulting from the institutional voids. Therefore, firms in an emerging economy are likely to obtain patent premium regardless of the weak institutions there. This leads to H1.H1: There is patent premium in China. To the extent that there is patent premium in an emerging economy, it is of interest to recognize how the magnitude of patent premium may vary with firm ownership. Here, we compare patent premium between foreign subsidiaries and domestic firms. Among the domestic firms, we further investigate how the extent of patent premium differs between state-owned and privately-owned firms. Foreign subsidiaries are distinct from domestic firms because they face considerable liabilities of “foreignness” (Zaheer, 1995) and “outsidership” (Johanson and Vahlne, 2009) in host economies. The challenges of being institutional outsiders (Khoury et al., 2014) manifest themselves in several aspects. First, foreign subsidiaries are less capable of fully understanding the nuances of local institutions, and can only to a limited extent rely on their experience with the legal system in their developed home country to protect their IPR in an emerging economy (Keupp et al., 2012). Second, firms may influence patent laws to their favor, especially in emerging economies with greater government intervention. Foreign subsidiaries ability to create these influence/policy rents is generally weaker. Occasionally they may even be discriminated against in legal enforcement (Peng et al., 2008), financial policy making (Delios and Beamish, 1999) and social norms such as whether bribery is acceptable (Peng, 2003). Third, while domestic firms in emerging economies are used to operating in their institutional voids and know how to circumvent them through a relationship-based strategy, foreign firms usually have problems to adapt and are stymied by these challenges (Khanna et al.,