Artificial Intelligence, Firm Growth, and Product Innovation

The article “Artificial Intelligence, Firm Growth, and Product Innovation” first appeared on Alpha Architect blog.

Recognize this topic of conversation?– Artificial Intelligence is transforming the way firms will operate, the way firms will innovate and ultimately, the way they will grow and increase profitability. Is that a true statement? You can probably think of specific examples where AI will have a major impact, including how firms will design new products, how rapidly those new products are delivered to us as consumers, probably before we even realize we want or need them! Is that really happening?  For the most part, yes.  But is it helping firms become bigger (think–market cap) and better?  The authors of this piece say yes to both. Firms that are investing in AI by hiring AI talent and adopting AI methodologies are outpacing their competitors in the product markets and becoming the “hot” stocks in the financial markets. How they accomplish that growth is the question.

Artificial intelligence, firm growth, and product innovation

• Tania Babina, Anastassia Fedyk, Alex He, James Hodson
• Journal of Financial Economics
• A version of this paper can be found here
• Want to read our summaries of academic finance papers? Check out our Academic Research Insight category.

What are the research questions?

1. Does a commitment to AI lead to firm growth?
2. Does AI achieve growth by reducing operating costs or expansion of product offerings and associated quality of those offerings?
3. How long does it take?
4. Does the availability of AI talent affect the adoption of AI?

What are the Academic Insights?

1. YES. AI-driven growth comes from sources across the spectrum–higher sales and employment and higher market valuation. From data covering the years 2010 to 2018, the authors report that a one-standard-deviation in AI investment was associated with a 19.5% increase in sales, an 18.1% increase in employment and a 22.3% increase in market valuation.
2. PRODUCT EXPANSION. The growth numbers cited above are not due to operational efficiencies but arise from the development of new products or from improving the quality of current products. Firms that adopt AI do show more product patents, trademarks, and more updates to their product portfolios than those that do not. The authors report no evidence that operating costs can be lowered by either improving the production process or replacing human labor with AI methods. It does not seem that AI is used improve firm efficiency by automating tasks. It is not the same as replacement by robotics, for example.
3. THREE YEARS. The effects of AI adoption materialize after 2-3 years. Firms begin to experience significant growth in sales and employment a few years after making investments in AI. Consistent with that timeline there are implications at the industry level. As industry sales and employment increase, so does industry concentration. It is more than likely that the benefits of AI will disproportionately accrue to larger firms reinforcing a “winner takes all, or almost all” competitive environment.
4. Firms that are connected to universities that produce a high number of AI graduates are more likely to adopt AI technologies. This study uses a binomial approach to show that firms with better access to AI talent from universities are better positioned to recruit AI-skilled workers, which drives their AI adoption. The availability of skilled AI talent is a critical component for AI adoption, and firms with connections to AI-universities are at an advantage. The raw correlations between job-postings and AI resume measures are presented in Panel 1 of Table 1. Take a look, they are quite high with a range of .32 to .57. Without that finding the conclusions about the impact of AI on firm growth and product innovation would only weakly reflect the significance of the conclusions and narrative we are currently forming around AI investments in the corporate world.

Why does it matter?
This study helps settle the record, convincingly, regarding misconceptions about firms that are AI adopters, and the authors thoughtfully leave us with a number of implications. Although AI’s primary benefit lies in its ability to boost innovation and growth, that won’t occur by replacing workers with AI or by cutting operating costs, as is generally feared. The authors of this study argue the benefits will materialize as expanded product offerings and enhancements to the quality of current product offerings. As it should be, this particular narrative should help allay the fears and trepidation that firms and investors may experience along the way to incorporating AI into the workplace. Patience will be required as well. The data presented here indicate the learning curve is of a gradual nature. Inequalities among firms will emerge as larger, cash-rich firms with better access to AI talent will enjoy a significant advantage. Those firms will likely dominate the corporate landscape as AI becomes established.

The most important chart in the paper

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged and do not reflect management or trading fees, and one cannot invest directly in an index.

Abstract

We study the use and economic impact of AI technologies. We propose a new measure of firm-level AI investments using employee resumes. Our measure reveals a stark increase in AI investments across sectors. AI-investing firms experience higher growth in sales, employment, and market valuations. This growth comes primarily through increased product innovation. Our results are robust to instrumenting AI investments using firms’ exposure to universities’ supply of AI graduates. AI-powered growth concentrates among larger firms and is associated with higher industry concentration. Our results highlight that new technologies like AI can contribute to growth and superstar firms through product innovation.