Institutions and Innovation: The Legal Environment of Innovating Firms

The literature on `national systems of innovation' emphasizes that the innovative capacity of nations depends on their institutions. This paper investigates the influence of an ideal-typical institution, law and regulations, on innovation, both directly and indirectly, through its influence on the organizational structure of — and cooperation between — firms that (may) engage in innovation. The paper starts by noting that innovation is fraught with risk and uncertainty which raise transaction costs. If these costs become too high, one would expect firms to refrain from investing in innovation. A major function of law and regulation is to reduce such risk and uncertainty. However, national legal systems differ in their capacity to reduce risk and uncertainty both effectively and efficiently. A typology of legal systems is introduced, based on two dimensions: an emphasis on regulation or on litigation; and an active or passive use of these. Subsequently, two legal systems are compared, which form more or less opposites in the typology, those of the United States and of the Netherlands. First, the possible direct effects of regulation on innovation are discussed. The American and Dutch legal systems are compared on the degree of activism of regulation, and the possible effect of both systems on innovation, through their influence on freedom versus predictability and through their technology-forcing effects. Second, the possible direct effect of litigation on uncertainty reduction and thus on innovation is considered. Third, the indirect effects of regulation and litigation on innovation are treated through their influence on organization, including inter-organizational relations. The conclusion is that, by comparison, the American system, with its emphasis on litigation, seems to be less effective and efficient in reducing uncertainty. Curiously enough, an institution, developed in order to reduce uncertainty, has itself become a new source of uncertainty. One would expect an economy with such a legal system to be less innovative. However, the opposite seems to be true. This paradox becomes understandable if one realizes that institutions are expressions of — and perpetuate — cultural values. Risk-averse cultures have legal systems that emphasize the reduction of risk and uncertainty. They also produce more risk-averse innovative behaviour in firms.