Study Blames Regulation for Lower Rates of Innovation

“The authors find that “there is a sharp fall in the fraction of innovating firms just to the left of the regulatory threshold,” which they label an “innovation valley” because the regulatory consequences of increased employee size mean that firms choose not to innovate. This fact holds for firms’ responses to demand shocks, as firms “with size just below the regulatory threshold” choose not to increase production to meet this demand because of the regulatory implications.
In total, the authors conclude that labor regulations equate to a 2.5 percent tax on profit, which reduces innovation by about 5.4 percent and “reduces welfare by at least 2.2% in consumption equivalent terms.” This tax on profit continues to affect firms to the right of the threshold, resulting in “a greater flattening of the positive relationship between innovation and firm size.”

The authors examine the effects of labor regulations on firms with between 10 and 100 employees, noting that “many labor regulations apply to firms with 50 or more employees,” and measure the firms’ innovative capacity by the number of patents.

These regulations force firms to devote resources away from production, including spending revenue on worker training, offering union representation, and creating profit-sharing schemes and a works council with employee representation.

“We are not saying all regulations are bad, but rather it is important to go beyond the usual approach to thinking about costs and benefits which are short-term and generally ignore long-run innovation,” Van Reenen tells Reason.”

“”Firms respond to incentives and disincentives and we find that even when firms experience positive developments, such as a surge in demand, they may still hesitate to invest in research and development and pursue innovation if they are near this size threshold,” Bergeaud explains to Reason. “Indeed successful innovation implies growth, which, in this case, would mean crossing the 50-employee threshold and incurring additional costs.”

Another interesting finding of the study is that firms innovating under substantive regulation tend to “swing for the fence” since “regulation deters incremental R&D” and firms want “to avoid being only slightly to the right of the threshold.” While significant innovations garner media coverage and drastically affect consumer well-being, minor innovations also provide benefits, allowing firms to deal with immediate concerns for less investment.”

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Coronavirus is a major test of America’s innovation industry

“the attention and resources dedicated to repurposing old drugs detracts from the pursuit of new therapies that would be true breakthroughs, exponential advancements in science. Feldman describes such innovation as “value beyond pearls.”
“It’s rare, it’s beautiful, it’s startling, it’s a thing of beauty,” she said.

But that kind of innovation takes time and money with no certain payoff. It’s simpler and cheaper to modify existing products to somewhat improve their efficacy or to tweak them to treat a different condition.

“I worry that our system is not well primed for it,” she said. “It’s all about the incentives. Our incentives aren’t directed properly.”

She pointed to the shift away from antibacterial resistance research and drug development, even though researchers anticipate millions of global deaths annually within the next few decades because bacteria have become resistant to the drugs that we already have to fight them.

Drug makers currently devote a lot of their attention to end-stage cancers, because they can benefit from “orphan drug” designation and other competitively advantageous policies, while Feldman argued that chronic conditions have been underserved. Looking at it from a societal perspective, the latter obviously has more value than the former — and yet that is not necessarily what our innovation system has been designed to reward.

Or look at the antiviral space, which is the most relevant to the coronavirus response.

Antiviral research investment historically has not been a priority for the major drugmakers. The Wall Street Journal reported Pfizer had to reestablish its antiviral research department for its Covid-19 work because the unit was disbanded in 2009. Novartis ended its antiviral and antibacterial research in 2018. One systemic review of the past 30 years of antiviral research found “only a few drugs were approved to treat acute viral infections” in that time.

“Antibiotics and antivirals are both areas that haven’t seen a tremendous amount of new drug development because the economic incentives haven’t justified significant R&D in this area,” Caroline Pearson, senior fellow with NORC-University of Chicago, told me recently.

So long as these incentive structures remain in place, Feldman warned, we will never be ahead of the curve in fighting off the next pandemic. She said that the US should be asking: “What’s of value and what should we incentivize people to do?””