Does labor regulation hurt innovation?

Those who believe that government regulations, including labor laws, hurt innovation, please, raise your hand. Wow, quite a few hands raised!

Indeed, the suspicion against regulations is fueled by common belief that they damage economic growth, with which innovation is intimately connected. For example, some scholars have expressed concerns that slower economic growth in Southern European and Latin America countries with heavy labor regulation could be due to reluctance to fund innovation programs because of the burden of labor laws (for references, see here). However, a point of view has been strongly articulated too that if applied effectively, regulation can foster a thriving, competitive marketplace where innovation and technological progress flourish. 

Interestingly, academic literature on the effects of regulation, in particular labor laws, on innovation seems to favor the second, more sanguine point of view.

For example, a 2010 study compared the innovation output in five countries—the U.S., U.K., France, Germany, and India–and found that stronger labor laws positively correlated with a country’s innovation output. Interestingly, this effect was more pronounced in innovation-intensive industries, such as medical devices, than in more traditional industries, such as textile. Equally importantly, the study found that the only dimension of labor laws that had a tangible impact on innovation was the “regulation of dismissal” component, i.e., the ease/difficulty with which employers could dismiss employees.

Another study published by the same authors in 2014 analyzed 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. The study found increase in the number and improved quality of patents issued in the states that adopted WDL, with the effect starting to emerge two years after the WDL passage. As in the previous work, the positive impact on innovation was significant only in highly innovation-intensive industries.

Taken together, both studies indicate that innovation is fostered by laws that limit firms’ ability to discharge their employees at will. The 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 by Berkeley’s Gustavo Manso in 2011. The concept postulates 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. Tolerance for early failures allows the employees to take risks at the initial stages of the innovation process without incurring the negative consequences of failed projects. The reward for long-term success encourages the employees to explore risky ideas that may allow them to achieve innovation breakthroughs in more distant future.

In other words, the best way to encourage risk-taking and experimentation is not to “celebrate failures,” as often suggested, but to remove the proverbial Sword of Damocles of punishment for them, something that any firm can easily do by modifying its termination policies.

A recent study adds an additional layer of complexity to the relationship between innovation and regulation. An international team of economists analyzed innovation outputs in France where many labor regulations apply to firms with as few as 50 employees. The authors found that regulations do negatively affect innovation, but in an interesting twist they saw that this regulation negatively affected only incremental, but not radical innovation. Using a sports metaphor, they concluded that “[a] more regulated economy may have less innovation, but when firms do innovate, they tend to ‘swing for the fence’ with more radical…breakthroughs.”

On emotional level, I hate regulations (hey, I grew up in the Soviet Union!). But regulations are part of our lives. There is no point in crying that “structure stifles innovation.” We should instead constantly look for ways to create conditions favoring innovation. Through regulations and otherwise.

Check out my eBook, “We the People of the Crowd…,” a collection of stories about crowdsourcing reflecting my personal experience in working with corporate and nonprofit clients.

Image credit: Paweł Czerwiński on Unsplash

About Eugene Ivanov

Eugene Ivanov is the Founder of (WoC)2, an innovation consultancy that helps organizations extract maximum value from the wisdom of crowds by coordinated use of internal and external crowdsourcing.
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