The media is full of stories of how red tape stifles innovation. There is not, however, really a coherent economic framework for thinking rigorously about this issue, let alone quantifying the magnitude of regulatory effects on the aggregate economy.
There is suggestive evidence to think that regulations matter. We take the example of France. Before 2018, when a firm reached 50 employees, it faced a veritable tsunami of labour laws including among other things establishing a works council, devoting a minimum fraction of revenue to training, forming a social plan with the labor ministry if it wanted to collectively dismiss workers and instituting a profit sharing plan with workers. All these may be desirable benefits, but they are also likely to have some costs.
Firms’ size and their innovation
It is well documented that, unsurprisingly, there is a bulge in the number of firms with between 45 and 49 employees, who appear reluctant to grow to 50 or larger (e.g. Ceci-Renaud and Chevalier, 2011). Figure 1 shows the power law describing the relationship between the size of firms and number of firms, which is linear in the logarithmic scale. In France, this firm size power law breaks down precisely around this regulatory threshold with a bulge in the number of firms before 50 employees and a shift down in the line afterwards.
Figure 1: The French Firm Size Distribution breaks at 50 employees
Discouraging productive firms from becoming larger is one “static” effect of the regulation. However, a deeper, more dynamic problem might be that firms may be reluctant to invest in growth-enhancing innovations when they face these higher regulatory taxes. Furthermore, even larger firms face this tax on growth, so they might invest less in research and development (R&D).
Figure 2 shows that these innovation effects might be happening in the data. The probability of innovating increases with firm size, but there is an “innovation valley” just before 50 employee firms consistent with a discouraging effect. Moreover, the gradient of the innovation-size relationship flattens after 50 employees, also suggesting a regulatory tax.
Figure 2: The innovation-firm size relationship has a “valley” around the regulatory threshold
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Dynamics
We formalize this notion in a Schumpeterian growth model with heterogeneous firm size (Klette and Kortum, 2004; Aghion, Akcigit and Howitt, 2014). Firms grow by improving upon existing product lines, thereby evicting the incumbent producers and replacing them on those lines. On the other hand, firms are in constant danger of being creatively destroyed by a new entrant or an existing rival on any product line they currently control, in which case they shrink by losing the product line. We then look at the effects of introducing a size-contingent regulation on firms’ R&D investments and on the firm size distribution in steady-state equilibrium. The model delivers exactly the kind of relationships we observe in Figures 1 and 2.
Our model also predicts that firms will respond very differently to demand shocks. Exogenous increases in demand (coming from an expansion in firms’ export markets, for example) will tend to raise R&D investments as firms’ rents from innovating increase accordingly. However, firms to the left of the regulatory threshold will respond much less, as they will gain less from innovation due to the regulation. This impact will be particularly strong for incremental innovations rather than radical innovations. The intuition is that if a company wants to innovate and pay the regulatory cost of moving beyond the 50 employee threshold, it may as well “go large” and swing for the fence. Moving slightly, say from 49 to 51 employees, is unlikely to make the R&D cost worthwhile.
We find exactly this pattern in the data. Figure 3 shows the impact of a market size shock on the incentive to innovate. For incremental innovation, as measured by low future citations, there is a large discouragement effect near the threshold. For radical, highly cited patents there is no effect. We show that the same is true if we use a measure of novelty of the patent based on a machine-learning algorithm as applied to the text of the patent (based on Kelly et al, 2018). Moreover, the cross sectional patterns in Figure 2 are all driven by incremental rather than radical innovation.
Figure 3: The impact of a demand shock on innovation as a function of firm size
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Macro Innovation and growth
Having shown that the qualitative implications of the model hold up, we then use the structure of the model to quantify the aggregate effect of regulation on innovation. This requires more assumptions, but the framework enables us to quantify the entire equilibrium impact through the innovation intensity and the firm size distribution. Compared to an unregulated benchmark, our baseline model estimates that the regulations reduce innovation and growth by 5% (e.g. from 2% to 1.9% per annum) and welfare by about 2%. These need to be added to the standard static misallocation losses other work has focused on (e.g. Garicano et al, 2016).
Policy Conclusions
Our analysis should not be taken to mean that the regulations are all bad. We have “priced out” the costs, but there could still be net benefits if society values job security extremely highly, for example. However, our findings do suggest the usual estimates of regulatory costs are understated when we ignore innovation. They suggest that reform to the regulations may have greater benefits than was previously thought.
Philippe Aghion is a professor at the College de France and at the London School of Economics.
Antonin Bergeaud is an economist at Banque de France.
John Van Reenen is a professor at the London School of Economics and at the Massachusetts Institute of Technology.
This article is an abridged version of the authors’ paper ‘The Impact of Regulation on Innovation‘, first published by the National Bureau of Economic Research. Read the full paper here.