Regulating an Innovative Industry

Innovations bring many benefits to society, but they can also bring harm. We study the problem of a regulator deciding whether to approve an innovation where information about the impact of the innovation is held within the firms that are developing it. We show that competition for the innovation undermines the regulator’s ability to extract the information she needs to make good policy. As the number of firms increases and the expected benefit of the innovation grows, the probability that the regulator is persuaded to approve an innovation decreases. This tension between competition and communication reverses Arrow’s famous “replacement effect.” Thus, in regulated markets, more competition can lead to fewer innovations making it to market. We explore how this tension can be mitigated, but not eliminated, by political and market design.