Increasing liability reduces platform innovation

Another area in which the liability regime is likely to have a significant impact on investments is innovation. A more stringent liability rule can affect both the rate and direction of innovation. First, the increase in the total cost of providing the service induced by the increase in liability costs will have an adverse effect on future profits from radical innovations that create new services, which could decrease platforms’ incentives to carry out such innovations. This argument holds not only for an incumbent platform but also for a potential entrant, thus highlighting another potential entry barrier induced by a more stringent regime. Note, however, that this argument may not apply to incremental innovations improving the quality of services that are already offered by an incumbent platform. The reason is that incentives to innovate are driven by the difference between post-innovation and pre-innovation profits, and, in this case, both terms may be affected by the increase in liability costs.

Second, a change in the liability rule applying to platforms may also affect the level of investments in innovation indirectly through its effect on competition between platforms. As emphasized before, a more stringent liability regime may lead to a decrease in competition because of an increase in entry barriers. Less intense competition will, in turn, affect the platform’s incentives to innovate. The long-standing literature on the effect of competition on innovation suggests that the level of innovation is either increasing in the degree of competition or is an inverse U-shaped function of competition intensity (see e.g., Aghion et al., 2005 and Vives, 2008). In both cases, a decrease in competition in a market that is highly concentrated (e.g., a market with a dominant platform) will tend to lower the incentives to innovate.