Environmental Regulation, Firm Heterogeneity and Innovation

Since Michael Porter (1991) has proposed that environmental regulation can help a firm increase its competitiveness by encouraging it to engage in more innovative activities to meet the environmental regulation, a number of researchers have empirically investigated the “Porter Hypothesis.” However, the empirical results still remain mixed. Combining the perspectives of the behavioral theory of the firm and firm heterogeneity, we argue that the levels of regulation stringency and time-pressure would differentially influence a firm’s innovative behavior depending on the firm’s aspiration level, performance feedback and technological capabilities. Using the U.S. Corporate Average Fuel Efficiency (CAFE) regulation context, we empirically demonstrate that lagging firms that do not meet the new regulation standard announced by the government tend to search for more distant knowledge and that the impact of the patents they file for decreases as the regulation becomes more stringent. In addition, we also find that as time-pressure increases, lagging firms stand to apply for more patents than do leading firms whereas the overall impact of the patents decreases. These results help us advance our understanding of the nuanced causal relationship between regulation and innovation and provide practical implications for policymakers.