Both formal and informal institutions affect economic behavior in important ways, as economist Douglass C. North explained in his 1993 Nobel Prize lecture. Formal institutions include laws and regulations, and informal institutions include culture and norms. In a recent study, we explore the effect of social capital, an informal institution, on corporate innovation.

Social capital consists essentially of the shared values and social networks that create trust, enhance cooperation, and facilitate transactions within a given community. In a newly accepted paper at Journal of Corporate Finance, we provide evidence that social capital can also facilitate contracting for innovation within a firm.

Contracting for corporate innovation is challenging because it requires executives and employees to work collectively without complete information. On one hand, corporate innovation depends on employees who are often assigned multiple tasks and led by corporate executives who are themselves the agents of shareholders. On the other hand, the interactions between corporate executives and employees are limited because they seldom engage in joint production. These issues can hinder corporate innovation as employees anticipate that executives will extract rent from successful innovation. Social capital can help to alleviate this problem by strengthening trust between employees and executives and facilitating contracting for innovation within a firm.

In our empirical framework, we use the strength of social norms (e.g., voter turnout rate and census response rate) and the density of social networks (e.g., total number of social organizations) in a county as a proxy for the level of social capital. We find that firms with corporate headquarters located in U.S. counties with higher levels of social capital file more patents in any given year, and the patents they file generate more citations in subsequent years. Beyond patents and citations, we find that social capital also improves the effectiveness of corporate R&D investment and increases a firm’s intellectual property, as measured by trademarks. The economic impact of social capital on corporate innovation is significant. Based on our estimates, a one-standard-deviation increase in the social capital variable in our data implies a net increase of three new patents filed in a given year, which amounts to about a 12 percent increase in patent-based innovation performance a year.

Not surprisingly, behavior varies from city to city and within a country. North has long argued that social norms and self-imposed codes of conduct are “humanely devised constraints that structure human interaction” and differ significantly from city to city. Whether local institutions affect business practices of large corporations has been unclear, but our research shows that they do. In particular, our work shows that social norms in even a small, local community can pervade large, for-profit organizations such as publicly listed corporations and affect their decisions.

This post comes to us from professors Iftekhar Hasan at Fordham University, Chun-Keung (Stan) Hoi at Rochester Institute of Technology, Qiang Wu at Rensselaer Polytechnic Institute, and Hao Zhang at Rochester Institute of Technology. It is based on their recent paper, “Is Social Capital Associated with Corporate Innovation? Evidence from Publicly Listed Firms in the U.S.,” available here.