Impact of formal institutional environment on innovativeness and performance

The institutional theory of strategy suggests that the external institutional environment of a firm has significant impact on its strategic behaviour and performance (Peng, Wang & Jiang 2008; Peng 2003; Ahn & York 2009). This theory argues that the institutional environment is a major determinant of the costs of exchange and production (North 1990). The current study contributes to the debate on institution-firm strategy-performance linkages in three folds. First, it attempts to measure four elements of the formal institutional environment of small and medium enterprises (SMEs) in two cities in the Philippines, one of the major developing countries in Southeast Asia. The focus is on sub-national or city-level formal institutions. Second, the study will determine the impact of the four types of formal institutions on the level of innovativeness and overall performance of SMEs in the two cities. It is argued that the level of innovativeness of SMEs partly depends on the extent to which firms consider the formal institutional environment to be conducive and supportive for innovative endeavours. Innovative SMEs are more likely to have better economic performance than those which are non-innovative. Third, the study will attempt to offer an empirically-based explanation on how the formal institutions influence firm performance by examining the mediating role of firm innovativeness. The study posits that the formal institutional environment can potentially facilitate, support or nurture the firms' innovativeness which ultimately leads to better performance. The paper starts with a discussion of the theoretical and conceptual basis of the study. This is followed by a discussion of the conceptual model and hypotheses that will be examined. The next section will be the empirical study and structural equation model analysis. The last part will be discussion of results and their research and practical implications.