Group #3 Jason Franken Prasanna Karhade Hsiao-Ching Lee Jennifer Shen Marko Madunic

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

2. …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

3. 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

4. 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

5. 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

6. 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

7. 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)

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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