The “labor law” of innovation

One might assume that pro-worker labor laws, due to their association with lower levels of investment, productivity and output, would have a negative effect on innovation. In fact, academic studies indicate that more stringent employment laws help firms and their employees pursue value-enhancing innovative activities.

The credit for pointing to a positive role labor laws play in the innovation process belongs to Viral Acharya of New York University Stern School of Business. In a 2010 paper, “Labor Laws and Innovation,” Acharya and co-authors explore how the legal framework governing the relationship between employees and their employers affect innovation output. The innovation output was measured by using the number of patents granted to a firm and the number of future citations received by each patent. The former number captures the quantity of the firm innovation and the latter its quality.

Acharya et al. first analyze the innovation output in five countries—the U.S., U.K., France, Germany, and India–which accounted for 72% of all patents filed with the USPTO between 1970 and 2006. This cross-country comparison shows that stronger labor laws positively correlate with a country’s innovation output. Interestingly, this effect is more pronounced in innovation-intensive industries, such as medical devices, than in more “traditional” industries, such as textile. Equally importantly, Acharya et al. find that the only dimension of labor laws that has a tangible impact on innovation is the “regulation of dismissal” component.

The authors further analyze the consequences of the WARN Act (Worker Adjustment and Retraining Notification Act), a federal law enacted by the U.S. Congress in 1988. The WARN Act requires most private employers with 100 or more employees to give a written notice to affected workers and local government 60 days before the date of a mass layoff or a plant closing. Employers who violate the WARN Act are liable for damages in the form of back pay and benefits to affected employees. The requirement of the Act increases the hurdles faced by employers when dismissing employees—and as such, have the same effect as dismissal laws. Acharya et al. show that the strengthening of dismissal laws via WARN had a positive impact on U.S. firm-level innovation: firms affected by WARN experienced increases in patents and patent citations by 43% and 71%, respectively, over the next five years when compared to firms that were not affected by WARN.

In a follow-up paper, “Wrongful Discharge Laws and Innovation,” published in 2014, Acharya and co-authors study the impact on innovation of the U.S. wrongful discharge laws (WDL). These laws provide employees with greater protection than employment-at-will, where employees can be terminated with or without just cause. The staggered passage of WDL across the U.S. states created a “natural experiment” assessing their impact on the innovation output. And this impact turns out to be quite impressive: the adoption of WDL results in a rise in the annual number of patents and patent citations by 12.2% and 18.8%, respectively, the effect starting to emerge two years after the WDL passage.

Moreover, the effect of WDL is evident not only at the firm but also at per employee level as evidenced by the increase of patents and patent citations by 12.3% and 19.0%, respectively, in states that adopted the laws vis-à-vis states that didn’t. As in the previous work, the positive impact on innovation is significant only in highly innovation-intensive industries.

Taken together, the data presented in both studies indicate that innovation is fostered by laws that limit firms’ ability to discharge their employees at will. Acharya and co-authors call this phenomenon an “insurance effect”: feeling increased protection from negative consequences of failure, employees are more committed to engaging in risky innovative projects.

These findings are fully consistent with a theoretical concept proposed, in 2011, by  Gustavo Manso (I wrote about it in my previous post) postulating that the optimal incentives motivating employees to innovate must include a combination of tolerance for failures in the short term and reward for success in the long term.

They also strongly suggest that the best way to encourage risk-taking and experimentation is not to “celebrate failures,” but to remove the proverbial Sword of Damocles of punishment for them, something that any organization can easily do by modifying its termination policies.

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About Eugene Ivanov

Eugene Ivanov is a PMI-certified Innovation Management Consultant who helps organizations increase the efficiency of their internal and external innovation programs.
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