The Impact of Regulation on Innovation in the United States: A Cross-Industry Literature Review

Luke A. Stewart November 14, 2011
November 14, 2011
How regulation can both stifle and encourage innovation.

Innovation—the commercially successful application of an idea from invention, the initial development of a new idea, and the widespread adoption of the innovation—is classified by whether the innovation benefits the market or social welfare. Market innovation typically benefits producers, consumers, and society at large, although there are cases where it may only benefit producers at the expense of social welfare. Social innovation refers to product and process innovations that create social benefits, such as cleaner air, which firms cannot directly capture through market sales.

Firms can also choose to innovate incrementally or radically. Incremental innovation occurs when firms make relatively minor improvements to existing products and processes to comply with regulation. Radical innovation occurs when a firm replaces existing products or processes to comply with regulation. This type of innovation is costly and risky; however, it can yield greater benefits than incremental innovation. 

Like innovation, regulations can be economic or social in nature. Economic regulation sets market conditions; it often changes the market efficiency and potentially affects the equality and fairness of the market. Social regulation, on the other hand, seeks to protect the welfare of society or the environment. When the scope of regulation is narrow, firms may choose to change their products or processes so that they are no longer within the scope of the regulation, also known as circumventive innovation. When the scope of the regulation is broad, firms may prefer to change its product or process to adhere to the regulation—otherwise known as compliance innovation. A regulation’s stringency, flexibility, and effect on available market information—collectively known as innovation dimensions of regulation—can have drastic impacts on innovation. Stringency is the degree to which a regulation requires compliance innovation and imposes a compliance burden on a firm, industry, or market. 

Generally, the more stringent a regulation is, the more radical compliance innovation is required. Thus, stringent regulation increases risk,cost, and the chances of “dud” products or processes. Flexibility describes the number of implementation paths firms have available for compliance. Information measures whether a regulation promotes more or less complete information in the market. Although flexibility and increased available information generally aid innovation (see Table D-1), regulation or the possibility of regulation can induce two types of uncertainty—policy and compliance uncertainty. Policy uncertainty occurs when a firm anticipates the enactment of a regulation at some time in the future and may cause firms to divert resources in preparation for future compliance. The degree of resources diverted depends on the anticipated stringency of the future regulation. Policy uncertainty may cause firms to innovate, even if regulations never become enacted. Compliance uncertainty is uncertainty caused by an existing regulation. This generally occurs when a firm does not know whether a product or process will comply with preexisting regulation or how much time is needed for the product or process to comply.