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Regulation and Innovation

Approaching Market Failure from Both Sides

Yafit Lev-Aretz†, Katherine J. Strandburg

Regulation is often claimed to be the enemy of socially desirable in- novation because of factors including innovation’s unpredictability and regulation’s compliance costs. In this essay, we bring two intellectual property scholars’ perspectives to bear on the question of regulation’s impact on innovation. We offer a novel, yet intuitive, analytical framework that takes both market demand failures, and failures of supplier appropriability into account. Traditionally, regulation seeks to mitigate market failures that create deviations between the demand portfolio per- ceived by suppliers and the socially optimal demand portfolio. Studies of the interplay between regulation and innovation have mostly taken this perspective, considering the impact of various regulatory transaction and compliance costs on innovation. Intellectual property law and competition law target a different sort of problem, where markets fail to supply products and services at competitive prices or to undertake innovative activities because of supplier appropriability issues.

We argue that these demand-misalignments and appropriability failures, though analytically distinct and commonly treated separately, work in parallel to determine the extent to which the market’s portfolio of innovative activity is socially suboptimal. Discussing the relationship between regulation and innovation in terms of demand misalignment, appropriability failures, and the mutual influence they bear on each other, opens up a new way of understanding this long debate. Our analysis shows the futility of sweeping generalizations about the relationship between regulation and innovation and highlights the crucial role of regulatory design.

From pharmaceuticals1 and environmental markets to DNA testing and big tech, the argument that regulation can “stifle” innovation has a long pedigree. Simply put, regulation is said to inhibit innovation by limiting potentially innovative paths and/or increasing innovation costs. As we claim in this Essay, however, the current popular debate around the interplay between regulation and innovation has suffered from much oversimplification. We hope to offer some careful unpacking to understand the relationship between regulation and innovation in broader, yet contextualized, terms.

To do this, we must first step back to consider the goals of classical regulation on the one hand, and of intellectual property (and to some extent competition law) on the other hand. The social benefits ascribed to competitive markets result from the assumption that consumer demand will induce suppliers to produce a socially beneficial portfolio of goods and services at competitive prices.5 The same assumptions underlie our reliance on markets to induce socially valuable innovation, since investments in innovation also are premised on perceptions of consumer demand. Of course, these assumptions sometimes fail. Through regulation, intellectual property law and competition law aim to address such failures. In this Essay, we explore the interplay between regulation and innovation by bringing traditional regulation together with intellectual property and competition law. In doing so, we clarify the interplay between them and add nuance to the currently oversimplified regulation-innovation debate.