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Even though firms? innovation efforts dwindle in reaction to weaker employment protection legislation (EPL), we show that the value of their investment opportunities actually increases. The reason is that weaker EPL discourages innovation efforts only in firms with little comparative advantage at innovation. At the same time, however, weaker EPL increases the financial and operating flexibility of firms. This flexibility gain can explain why Tobin?s q increases in reaction to weaker EPL.

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