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Appendix D
Abstract of “The Impact of Regulation
on Innovation in the United States: A
Cross-Industry Literature Review”
1
Luke A. Stewart
INTRODUCTION
Through a high-level, multi-industry review of the literature, this paper
describes how regulation can both stifle and encourage innovation. The
impact of regulation on innovation depends largely on the breadth and
type of the regulation.
REGULATION AND INNOVATION
Innovation—the commercially successful application of an idea from
invention, the initial development of a new idea, and the widespread adop-
tion 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 exist-
ing 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.
1 Full commissioned paper is included on the CD in the back of the book.
189
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190 HEALTH IT AND PATIENT SAFETY
Like innovation, regulations can be economic or social in nature. Eco-
nomic regulation sets market conditions; it often changes the market effi-
ciency 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 flex-
ibility 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 exist-
ing 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.
FINDINGS AND CONCLUSIONS
While it was found that the degree by which regulation affects innova-
tion is highly variable and case specific, several common themes emerged:
• Policy uncertainty affects expected future regulation and can stifle
innovation.
• Flexible regulations generally aid both market and social innovation.
• More complete market information aids innovation.
• Economic regulation tends to stifle market innovation.
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191
APPENDIX D
TABLE D-1
Selected Attributes of Regulations and Their Theoretical Impacts on Innovation
Compliance Compliance Innovation
Regulation Burden “Dud” Inventions Innovation
Flexibility
Command and control Higher – –
Incentives based Lower – –
Specification standards Higher More –
Performance standards Lower Less –
Information
Compliance value added Lower Lower –
Compliance uncertainty Higher – –
Stringency
None/
Moving target Lower Less
Incremental
Disruptive regulation Higher More Radical
• Social regulation tends to stimulate social innovation; however,
more often than not, it stifles market innovation.
• Some evidence suggests more stringent and disruptive social regula-
tion promotes more radical innovation, while the “moving target
approach” of gradually increasing stringency over time results in
incremental innovation.
• Regulation that does not require innovation for compliance will
generally stifle innovation, although it may spur circumventive
innovation if the firm or industry can find a path to escape the
regulatory constraints.
• Regulation that does require compliance innovation has an unclear
impact on innovation.
• A tradeoff exists between market innovation that benefits the firms
and that which serves only to meet the compliance standards of
regulation.
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