When private actions generate harmful externalities, previous research has shown that public intervention can improve welfare if it appropriately trades off social harm reduction with enforcement costs. On the flip side of this, however, public intervention may thwart the firm’s incentives to undertake research by reducing its expected profitability, depending on the approach used.
Giovanni Immordino, Marco Pagano and Michele Polo consider public policies and approaches that may affect a firm’s effort to discover new technologies and the actual use of that technology once discovered in their paper, “Incentives to innovate and social harm: Laissez-faire, authorization or penalties?” They compare four different regulatory responses: 1) laissez-faire; 2) a lenient authorization regime, where inventions can be used commercially once they are ascertained to be safe during tests; 3) a strict authorization regime, where they can be used commercially only if they are ascertained to be beneficial; and 4) a regime based on penalties, where the commercial use of innovations is sanctioned ex-post if found to be harmful.
There results indicate that the regulatory regime should become more stringent and cogent as the danger of social harm increases. In other words, “if fines are unbounded, laissez-faire is optimal if the social harm from innovation is sufficiently unlikely; otherwise, regulation should impose increasing penalties as innovation becomes more dangerous.” Furthermore, if fines are bounded by limited liability, “it is optimal to adopt (indifferently) penalties or lenient authorization, while strict authorization becomes optimal if social harm is sufficiently likely.”