Regulation with Experimentation: Ex Ante Approval, Ex Post Withdrawal, and Liability

Abstract

The introduction of possibly unsafe products, the granting of patents, and more generally the dynamic adoption of activities with uncertain externalities are characterized by two phases. In the ex ante pre-introduction phase, costly experimentation is undertaken to decide whether it is worth entering the market or abandoning experimentation. In the ex post learning phase, the decision is made whether to stay in the market or withdraw following the accumulation of bad news. Through a novel and tractable continuous-time model featuring these two phases of ex ante experimentation and ex post learning, we draw positive and normative implications for the balance of the three main tools used to regulate private incentives: liability, withdrawal, and authorization. Shedding light on the preemption doctrine, we find that liability should be preempted to avoid chilling of activities that generate large positive externalities. For activities that generate small positive externalities, instead, liability should be used to discourage excessive experimentation. Authorization regulation should be lenient whenever it is used, consistent with how regulation is structured in a number of areas ranging from safety to patents.