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Government regulation involves implementing social and economic policies using legal instruments which can compel individuals or organisations to comply with prescribed behaviour under penalty of sanctions. Corporations can be forced, for example, to observe certain prices, to supply certain goods, to stay out of certain markets, to apply particular techniques in the production process or to pay the legal minimum wage. Sanctions can include fines, the publicising of violations, imprisonment, an order to make specific arrangements, an injunction against withholding certain actions or closing down the business (Van den Bergh 2016).

The ‘normative theory of regulation’ (Huesig et al. 2014) deals with reasons for regulation due to market failures, which can include external effects, natural monopolies, public goods availability, sunk costs, ruinous price war, universal service, interconnection, cross-subsidisation and asymmetric information in relation to economically important sectors. Economies of scope, which occur in network industries, are another means of justifying legislation. Where economies of scope exist, it is more efficient for only one company to produce goods. This again may justify government intervention. Regulatory instruments for intervening in markets include barriers to market access and price regulation. Regulation shapes the motivations and abilities of incumbents in these markets, changing their behaviour and, implicitly, influencing their decisions. This suggests government regulation may be one of the main drivers in any market because the existence of legislation has the potential to substantially change the motivation and ability of both new entrants and incumbents (Christensen et al. 2004).

One of the key issues confronting firms is the degree to which new government regulations might influence their innovation strategies. One area of regulation which has had a major impact on firms is the issue of environmental protection, especially in relation to controlling pollution. Porter and Van der Linde (1995) suggested that pollution is generally associated with a waste of resources or with lost energy potential. They argued that reducing pollution often coincides with improving productivity, which implies that properly designed environmental regulations can trigger innovation that may partially or more than fully offset the costs of complying with them. This concept, whereby innovation that simultaneously controls emissions and production costs results in a ‘win- win’ scenario, has come to be known as the ‘Porter hypothesis’ (or PH).

Jaffe and Palmer (1997) presented three distinct variants ofPH theory. In their framework, the ‘weak’ version of the hypothesis is that environmental regulation will stimulate certain kinds of environmental innovations, but there is no suggestion that the direction or rate of this increased innovation is socially beneficial. Their ‘narrow’ version of the hypothesis asserts that flexible environmental policy instruments, such as pollution charges or tradable permits, give firms a greater incentive to innovate than prescriptive regulations, such as technology-based standards. Finally, they posited that the ‘strong’ version involving properly designed regulation may induce innovation that more than compensates for the cost of compliance and improves the financial situation of the firm.

Given this potential for the existence of win-win scenarios, PH theory is relevant not only for public policymakers, but also for managers of firms. If the strong version of the hypothesis is valid, managers could be much less fearful of stricter government intervention with respect to environmental issues, especially when this comes in the form of flexible policy instruments which could affect their attitude towards seeking to resist new legislation. Furthermore lead firms would be willing to reconsider their production processes in order to identify and correct all possible inefficiencies associated with negative environmental impacts.

To assess the validity of the PH concept, Laurent-Lucchetti et al. (2011) undertook a large-scale, quantitative evaluation of pollution management projects in seven OECD countries. They concluded that in relation to the weak version of the hypothesis, environmental policy does induce innovation. This occurs because environmental policy that changes the relative price (or opportunity cost) of environmental factors of production encourages facilities to identify means of economising on their use. With respect to the narrow version of the hypothesis, they concluded that more flexible performance standards are more likely to induce innovation than more prescriptive technology-based standards because they give firms the incentive to seek out the optimal means to reduce their environmental impacts. This has important implications for public policy and supports the trend towards ‘smart regulation’. In contrast the researchers found no supporting evidence for the strong version of the hypothesis. This is because the direct effect of stringent environmental policy regulation on business performance is negative, due in large part to the scale of investment necessary to comply with tight regulations which create additional production costs that can only be partially offset by investment in innovation.

The issue of stringent regulation is not just restricted to environmental issues. In most Western nations over recent years, politicians seeking to satisfy the demands of their electorates have tended to introduce ever more draconian legislation across a number of industrial sectors. This situation has caused some industry observers to posit that excessively tight legislation is reducing the competitiveness of many firms relative to their competitors based in developing nations. Kennedy (2015), for example, has argued that for the United States to regain the commanding heights it occupied during the 1980s, there needs to be regulatory reform across many sectors of the economy including healthcare, education and energy. This is because many sectors, weighed down with regulations that make it difficult to displace incumbent practices with new and better methods, have exhibited decades of low productivity and little innovation. According to Kennedy, over-regulation also threatens new technologies such as drones, driverless cars and medical applications that, if properly developed, could deliver huge economic and social benefits.

Kennedy posited that excessive regulation impeding innovation reflects excessive concern by government about imposing order with the aim of reducing risk. Regulatory agencies tend to focus on the risks posed by a lack of regulation, when in reality bad regulations have their own costs, both in terms of delay and in preventing positive innovations from entering the market. For example, although an expensive and lengthy drug approval process probably does minimise the chance of a dangerous drug being approved, it also makes it harder for every good drug to reach the market. Kennedy also noted that overly prescriptive regulation does not always protect consumers and pointed out that customers increasingly have access to information about the cost and quality of goods and services. Social media and the courts offer powerful tools for punishing companies that offer shoddy products. In many markets new entrants have the potential to exploit innovation to offer superior or higher-value convenient alternatives and government agencies have the potential to do consumers a disservice by imposing heavy regulatory costs on suppliers and outlawing competition.

 
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