Judicial Errors and Innovative Activity

We analyze the effect of judicial errors on the innovative activity of firms.
If successful, the innovative effort allows to take new actions that may be ex-post wel-
fare enhancing (legal) or decreasing (illegal). Deterrence in this setting works by affecting
the incentives to invest in innovation (average deterrence). Type-I errors, through over-
enforcement, discourage innovative effort while type-II errors (under-enforcement) spur it.
The ex-ante expected welfare effect of innovations shapes the optimal policy design. When
innovations are ex-ante welfare improving, laissez-faire is chosen. When innovations are
instead welfare decreasing, law enforcement should limit them through average deterrence.
We consider several policy environments differing in the instruments available. Enforcement
effort is always positive and fines are (weakly) increasing in the social loss of innovations. In
some cases accuracy is not implemented, contrary to the traditional model where it always
enhances (marginal) deterrence, while in others it is improved selectively only on type-II
errors (asymmetric protocols of investigation).