Working Paper Series no. 804: The Impact of Regulation on Innovation

Does regulation affect the pace and nature of innovation and if so, by how much? We build a tractable and quantifiable endogenous growth model with size-contingent regulations. We apply this to population administrative firm panel data from France, where many labour regulations apply to firms with 50 or more employees. Nonparametrically, we find that there is a sharp fall in the fraction of innovating firms just to the left of the regulatory threshold. Further, a dynamic analysis shows a sharp reduction in the firm's innovation response to exogenous demand shocks for firms just below the regulatory threshold. We then quantitatively fit the parameters of the model to the data, finding that innovation at the macro level is about 5.4% lower due to the regulation, a 2.2% consumption equivalent welfare loss. Four-fifths of this loss is due to lower innovation intensity per firm rather than just a misallocation towards smaller firms and lower entry. We generalize the theory to allow for changes in the direction of R&D, and find that regulation's negative effects only matter for incremental innovation (as measured by citations and text-based measures of novelty). A more regulated economy may have less innovation, but when firms do innovate they tend to “swing for the fence” with more radical (and labour saving) breakthroughs.

There is an important literature that looks at the impact of regulation on growth at the macroeconomic level and there is a wide consensus that unsuitable institutions might lead to regulations that would deter growth. However, microeconomic evidence are harder to find and there is not really a coherent economic framework thinking rigorously about this issue, let alone quantifying the magnitude of the effects on the aggregate economy.

In this paper, we exploit the fact that in France, a number of labour regulation laws affect firm whenever they reach 50 employees (but not before). We use firm level data to look at the impact of such threshold.  First, such size-dependent regulation discourage productive firms from becoming larger. This effect was already emphasized in Garicano et al. (2016). However, a deeper problem might be that such firms are reluctant to invest in growth enhancing innovations. This is the channel that we consider in this paper. More precisely, we show that firms innovate less when they approach 50 employees. We develop a theoretical framework of firm dynamics and innovation which rationalize this finding. In this framework, firms that are just below the regulatory threshold are reluctant to invest into R&D as a successful innovation will make them cross the threshold, and face the new regulation.

To show that our finding are consistent with this story, we consider the innovation response of firms to positive demand shocks. We show that when there is more demand for a good, firms producing these goods respond in innovating more proportionally to their size. This relationship between size and innovation is no longer true for firms that are between 45 and 49 employees. Yet, only incremental innovation is concerned by this mechanism as if firms are going to innovate and pay the cost, they may as well “go large” and swing for the fence.

We finally use our model and the data to calibrate the overall impact of this regulatory threshold on innovation. Compared to an unregulated benchmark, the regulations reduce innovation and growth by 5% (e.g. from 2% to 1.9% pa) and welfare by about 2%.

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Working Paper Series no. 804: The Impact of Regulation on Innovation
  • Published on 01/29/2021
  • 78 pages
  • EN
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Updated on: 01/29/2021 15:58