strategic intellectual property rights policy and north-south technology transfer

Strategic Intellectual Property Rights Policyand North-South Technology Transfer

Alireza Naghavi

University of Modena and Reggio Emilia

Abstract: This paper analyzes welfare implications of protecting intellectual prop-erty rights (IPR) in the framework of TRIPS for developing countries (South)through its impact on innovation, market structure and technology transfer.In a North-South trade environment, the South sets its IPR policy strategically tomanipulate multinationals’ decisions on innovation and location. Firms can pro-tect their technology by exporting or risk spillovers by undertaking FDI to avoidtariffs. A stringent IPR regime is always optimal for the South as it triggers tech-nology transfer by inducing FDI in less R&D-intensive industries and stimulatesinnovation by pushing multinationals to deter entry in high-technology sectors.JEL no. O34, F23, F13, L13, O32, L11, O38Keywords: Intellectual property rights; technology transfer; multinational firms;foreign direct investment; North-South trade

1 Introduction

Protection of intellectual property rights (IPR) has been an issue of ris-ing interest in both industrialized and developing countries (South). Thecontroversies tend to center on the relatively new Trade Related Aspectsof Intellectual Property Rights (TRIPS) agreement of the Uruguay roundof GATT, which has called for a standardization of IPR protection amongall members of the World Trade Organization (WTO) and potential newentrants. It requires developing countries to raise their intellectual propertyprotection level to the standard in force in industrialized nations at thetime of negotiation.1 The agreement was a consequence of complaints andlobbying undertaken by technology intensive firms in the North claiming

Remark: I am grateful for invaluable guidance by Peter Neary while working on this paper.I also wish to thank Richard Baldwin, Dermot Leahy and Gianmarco Ottaviano for help-ful comments. Please address correspondence to Alireza Naghavi, Universita di Modenae Reggio Emilia, Dipartimento di Economia Politica, Viale Berengario 51, I-41100 Mod-ena, Italy; e-mail: [email protected] TRIPS does however offer flexibility for developing countries and economies in transi-tion. They are granted a four-year transition period (10 years for least developed countries

© 2007 Kiel Institute DOI: 10.1007/s10290-007-0098-8

56 Review of World Economics 2007, Vol. 143 (1)

to have lost billions of dollars through infringement of their property rightsdue to loose IPR protection regimes in the South. These firms urged theWTO to bring this issue into the ambit of GATT, arguing that weak IPRprotection lowers trade volume, distorts trading patterns, and deters firmsfrom transferring technology abroad. Developing countries have howevercontinuously resisted adopting stronger IPR legislation and its enforcementwith the fear that foreign interests would be the only beneficiaries of suchpolicies at the expense of domestic consumers. A question often asked iswhether such behavior is rational when it has a direct effect on the behaviorof multinationals and if it could be justified in terms of welfare.

The literature on IPR has been shifting back and forth from those againstprotecting IPR to others in its favor. In the early 1990s theoretical economistshighlighted the negative consequences of such policies for the South. Theyshowed the static welfare effects of IPR protection by examining the trade-off between the incentives it creates to innovate and the monopoly marketpower it yields to innovators. Chin and Grossman (1990) and Deardorff(1992) clearly displayed these trade-offs in a static welfare analysis. Bothpapers showed that the North always wins and the South generally loseswhen the latter adopts a patent policy from the North. Zigic (1998) extendedthis model to allow for different levels of IPR protection and found that whilethis conflict holds when research and development (R&D) efficiency is low,the interests could actually be in congruence for moderate and high R&Defficiency levels. Similar to Chin and Grossman (1990), it used a two-stagegame with an exogenous IPR policy, where the Northern firm chooses theoptimal level of R&D in the first stage and competes with a Southern firm inthe second stage. It should be kept in mind however that recent examples inthe world such as the refusal by South Africa to abide by the TRIPS agreementwith regard to pharmaceutical drugs have shown that governments in theSouth do possess the authority to choose their IPR regime.

A sharp rise in international investments in the 90’s and a remarkableincrease in the degree of IPR protection in the same period has nonethelessraised inquisitiveness about the link between technology transfer and IPRprotection (Maskus 1998). This led the IPR literature to a turn in favor ofIPR protection by analyzing firms’ decisions on the form and the amountof technology transfer to the South. Helpman (1993), Lai (1998), and Yang

extendible upon request) to adapt to the required obligations with an additional five yearsfor technology-oriented product patents not protected at the date of agreement (Bragaet al. 2000).

Naghavi: Strategic Intellectual Property Rights Policy 57

and Maskus (2001) were among these papers and used endogenous growthmodels to show that protecting IPR could benefit the South by increasingthe flow of technology to the South.2 This branch of the IPR literature hasfocused on the consequences of IPR protection on the rate of innovationand the rate of foreign direct investment (FDI) leaving room for more workto be done on issues involving welfare.

More recent interesting work has focused on the welfare implicationsof TRIPS. Grossman and Lai (2004) for example use a rich framework toargue against globally harmonized IPR standards by showing the adverseeffects of IPR protection for the South in a trade environment.3 Lai and Qiu(2003) further show the IPR protection standard in the South to be naturallyweaker than that in the North. Differently, Connolly and Valderrama (2005)introduce a North-South dynamic model of technological diffusion throughtrade and imitation to show that increasing Southern IPRs could be welfareenhancing for both regions. While producing a rich set of results, the analysisin this branch of literature also abstracts from the role of FDI in technologytransfer.4 Yet, technology transfer through FDI plays a central role in growthand development and hence welfare of the least developed regions of theworld.

The model presented in this paper takes a step further and present a wel-fare analysis explicitly for the South that embodies the consequences of theSouthern IPR policy on foreign investment, market structure and innova-tion. It endogenizes Southern IPR policy and the Northern firm’s decisionon whether to serve the Southern market through exports to obstruct expo-sure of its technology or by engaging in FDI to avoid trade costs. The latteroption could cause a spillover of its innovative technology to the Southernfirm, the level of which is determined by the IPR regime in the South. The

2 The first basic model of this was introduced in the last section of Helpman (1993) toinclude FDI. It was shown that with exogenous innovation, FDI rises with a tightening ofSouthern IPR protection. Lai (1998) extended the model to show that when FDI is thechannel of transfer, the rate of innovation also increases along with the rate of FDI asa result of a tighter IPR protection policy. Yang and Maskus (2001) showed that when thechannel of diffusion is licensing, both rates of innovation and technology transfer increasedue to lower transfer costs and less rent sacrifice for the licensor to prevent imitation bythe licensee.3 This paper applies patent length as opposed to the level of spillover as an indicator ofIPR protection.4 Recent empirical work by McCalmen (2001) also suggests that the South has been worseoff with the TRIPS agreement using the resulting transfers of income from the South tothe North as evidence. Gains from FDI and technology transfer are also absent in his an-alysis.


Northern firm can still deter entry after relocation by choosing the exactlevel of R&D investment that makes it unprofitable for the Southern firmto produce. Shedding light on these missing points in the strategic IPRliterature, this paper overturns the results attained in the existing literatureand shows that the South can always gain from enforcing a stringent IPRregime in terms of welfare, either by attracting foreign investment in lessR&D-intensive industries or by simulating innovation in high-technologysectors.

The game takes place in five stages. In the first stage, the Southerngovernment sets the optimal IPR protection level strategically. In the secondstage, the Northern firm decides its mode of supply, namely whether toexport, or to move production to the South. The latter choice itself consistsof the two options of duopoly or entry deterrence. The South chooses itstariff policy in the third stage. The Northern firm then invests in R&D inaccordance with its decision from the second stage and finally firms engagein production. The timing is chosen in this manner in order to specificallyreflect the capability of the TRIPS agreement. It shows how TRIPS is able toeliminate moral hazard problems that could occur if the IPR policy is leftflexible to be set at a later stage. That is to say once in the WTO (and hencea signatory of TRIPS), a government necessarily enjoys the credibility tocommit to its IPR policy before firms make their choices.

The rest of this paper is structured as follows: Section 2 presents thebasics of the model following Chin and Grossman (1990) and Zigic (1998)and briefly examines the final production stage of the game. Section 3introduces the options faced by the Northern firm regarding the supplymode. It then calculates the optimal R&D investment for each case anddiscusses the multinationalization decision of the Northern firm. Section 4finds the optimal IPR regime for the South and reveals the equilibriummarket outcome. Finally, Section 5 concludes the paper.

2 The Model

2.1 Assumptions

There are two countries, the North and the South, with one firm residingin each country.5 Firms produce a single homogeneous good. A familiar

5 It is straightforward to extend the model to allow for more firms in the South, but thisdoes not yield any additional significant insights (see Section 4.2).


linear inverse demand (market clearing price) P = A − Q is used whereA represents the size of the market and Q the total quantity produced bythe North and the South: Q = qn + qs. As our market of interest is theSouth here, only goods targeted particularly at the Southern market areconsidered. Alternatively, a segmented market framework can be used inwhich the Northern firm produces for both markets, but perceives the twomarkets to be different; therefore, its optimization problem for the Southernmarket is independent of that for its domestic market. This is also known asdifferential pricing, which is an economically rational way for multinationalsto maximize their profits on products that are sold in both low and highincome markets.6 Southern consumer surplus is then simply the area underthe demand curve:

S = (qn + qs)2

2. (1)

While under exporting the South tries to acquire whatever information itcan from the imported products, FDI involves explicit trade in technology.Encouraging FDI not only imports more efficient foreign technologies intothe South, but also generates technological spillovers for local firms. Saggi(2002) gives a complete survey on trade, FDI and technology transfer, anddivides potential channels of spillovers into demonstration effects, laborturnovers and vertical linkages. As we are dealing with IPR protection asthe main theme in this paper, we consider the first two types, which arespillovers that go to non-related Southern firms.

The demonstration effect states that it may simply be too costly for localfirms to acquire the necessary information for adopting new technologies ifthe latter are not first introduced (demonstrated) in the local economy bymultinationals.7 The argument is especially true for poor countries that arenot as well integrated into the world economy and have few alternative chan-nels of absorbing technologies. FDI hence expands the set of technologiesavailable to local firms. On the other hand, labor turnovers refer to know-ledge embodied in workers moving across firms through the movement of

6 A good example of this is medicine for AIDS. Being forced to reduce prices of theirproducts for consumption in the South, pharmaceutical firms now engage in price differ-entiation. A ban on parallel imports of medicines into the US and the EU is enforced toassure segmented markets (Maskus 2000a).7 Parente and Prescott (1994) provides evidence to argue that a greater investment byfirms is required to adopt a new technology the larger are the barriers to technology adop-tion such as geographical proximity.


workers. A number of empirical studies discuss the role of labor turnover indisseminating technologies of multinationals to local firms. They all con-clude that a great number of managers and workers leave multinationalsto set up their own firms or to join other newly established local firms.8

FDI in poor countries hence trains workers and sends them out to createa local market. As we are interested in studying explicit channels of technol-ogy transfer, we follow this literature and assume that the Southern firm isincapable of acquiring the production technology unless the Northern firmmoves production to the South (or so to say the technological barriers are“binding” when market is served through arm’s length). Allowing for imi-tation with both imports and FDI takes away the significance of technologytransfer, as the South would simply prefer to import in order to enjoy tariffrevenues.9 The Northern firm hence enjoys a monopoly position if it pro-duces at home, whereas moving production to the South creates a Cournotduopoly setting by giving a Southern firm the opportunity to enter themarket.10

An example for such market structure is the Bangladeshi garment indus-try, where 115 of the 130 initial workers of the first garment manufacturerin Bangladesh, Daewoo/Desh, left to set up their own firms or join newlyestablished firms (UNCTAD 1992).

Finally, the Northern firm is capable of engaging in R&D aimed at in-novating more cost-effective production technologies.11 Knowledge gainedthrough R&D is however assumed to have a public good character and canbe imitated at zero cost. The unit cost function for the Northern and the

8 Katz (1987), Rhee (1990), Hobday (1995) and Pack and Saggi (1997) show this for LatinAmerica, the Bangladeshi garment industry, East Asia, and Taiwan, respectively.9 As the paper focuses on process innovation (patent of technology) rather than productimitation it does not consider cases where innovation is negligible and no unique key tech-nology is required for production. Imitation of imported goods gains greater importancein a context of copyrights or trademarks, where industries such as the CD or the apparelindustry suffer from pirating and reproduction (Maskus 2000b).10 Being interested in patents and imitation, we abstract from differentiated goods in thismodel and explore the effects of IPR protection on a single homogeneous good. This nar-rows down our analysis to a partial equilibrium approach, which focuses on one industry.Recent studies such as Neary (2003) construct a general oligopolistic equilibrium (GOLE)setting where firms compete in oligopoly in their own sectors, but cannot affect wages andprices in the whole economy. An extension of the model into the GOLE framework wouldbe an interesting line of future research.11 This assumption can be justified by the fact that less than 1 percent of existing patentsare held by developing countries (see Appendix C in Zigic (2000) for the R&D expendi-tures statistics of the North and the South).


Southern firm is respectively

C = α − (gx)1/2 , (2)

c = α − β(gx)1/2 , (3)

where x ≤ α2/g and A > α. Variable x is the cost-reducing R&D investment,g is the efficiency of the R&D process, α is the pre-innovative basic unit costs,and β = bι is the level of technology spillovers.12

The parameter β is itself a product of the imitation cost 0 ≤ b ≤ 1 (withb = 0 and b = 1 reflecting infinite and no imitation cost, respectively) anda measure of the IPR protection in the South 0 ≤ ι ≤ 1 (with ι = 0 and ι = 1reflecting full and no protection, respectively), and determines the degreeof spillovers.13 The imitation cost depends on such factors as the complexityof the knowledge generated and the level of development of the South, andis exogenous. A lower b only leads to diminishing importance of IPR in theFDI decision of the Northern firm because it makes its technology morecostly to copy. Therefore, we use the spillover level β to focus on changes inthe level of IPR protection in the rest of the paper and take b as given.

The timing of the game is illustrated in Figure 1, where actions by theNorthern firm are shown in white and those of the South are specified withshaded boxes. The next section briefly explains the fifth stage of the game,namely the production stage, where the firms compete in quantity.

2.2 Production

The Northern firm maximizes its profits, which consists of operating profitsless the research expenditure and in the case of exports less the total tariffcosts:

Maxqn

πn(x) = [A − (qn + qs)] qn − Cqn − tqn − x . (4)

The profits of the Southern firm on the other hand are zero if the Northernfirm stays at home, or simply its operating profits in the FDI case. The lattergives the maximization problem of

Maxqs

πs(x) = [A − (qn + qs)] qs − cqs . (5)

12 Note that R&D reduces the unit cost of production at a diminishing rate.13 This method is adopted from Leahy and Naghavi (2006), which uses b to represent theabsorptive capacity of the South.


Figure 1: The Stages of the Game

The optimal quantity produced by the Northern firm for exports is derivedfrom the first order condition of (4) with respect to qn, while setting qs tozero due to the monopoly position to get

qnm∗(x) = A − α + (gx)1/2 − t

2. (6)

Subscript m denotes monopoly exporting. If FDI is the outcome, firms en-gage in competition and maximize profits with t = 0. The optimal quantitiesproduced by each firm under FDI are

qnf∗(x) = A − α + (2 − β)(gx)1/2

3, (7a)

qsf∗(x) = A − α − (1 − 2β)(gx)1/2

3, (7b)

for the Northern and the Southern firm, respectively, where subscript fstands for FDI. The optimal R&D investment and profits are found for


exports and FDI in the next section, where the Northern firm comparesprofits to decide how to serve the Southern market.14

3 Northern Firm’s Multinationalization Problem

3.1 Export

If the Northern firm is highly concerned about the infringement of its tech-nology, it could decide to keep production in the North and export thefinal good to the South. This serves as an indirect protective act by theNorthern firm to avoid the imitation of its technology. Using data on USexports and sales of multinational affiliates of US firms, Ferrantino (1993)reveals that the US exports more to its affiliates in countries with a weakIPR regime. The evidence suggests a desire to conceal information aboutthe production process by keeping production in the US to optimize againstpolicies and market conditions in a host country. Exporting rather thanmoving production to the South as a response to weak IPR protectionis also confirmed by Smarzynska Javorcik (2004) who provides empiricalevidence that the latter deters foreign investors from undertaking local pro-duction in Eastern Europe and shifts them towards distribution of importedproducts.

While saving its technology from being imitated, exporting incurs extratrade costs for the Northern firm. The only other IPR-related strategicliterature to our knowledge that relates tariffs to IPR policy is Zigic (2000).The paper introduces strategic trade policy into the IPR context; however,it only focuses on Northern welfare and leaves out the implications for theSouth. A punitive tariff is imposed on goods exported back to the North todeal with the violation of property rights in the South. In the model in handby contrast, tariffs serve the purpose of making the problem a trade-offbetween trade costs savings and losses caused by imitation.

As was already indicated in Section 2.1, if goods rather than the technol-ogy are imported, it is assumed to be too costly and therefore impracticablefor the South to invent around the patent as it is in the possession of no R&Dresources. The optimal R&D investment in this case can be found from the

14 This paper only analyzes the decision between exporting and FDI and does not dif-ferentiate between the different forms of the latter. Vishwasrao (1994) and Leahy andNaghavi (2006) are among papers that deal with the role of IPR on the decision of multi-nationals about the mode of foreign investment.


first order condition of (4) with respect to x, using qnm∗ as the monopoly

output:

xm∗(τ) = g(1 − τ)2

(4 − g)2. (8)

In order to simplify the notation in the upcoming equations, we havenormalized the unit tariff rate t by the size of the market and referred toit as 0 ≤ τ ≤ 1 to get t = τ (A − α).15 It can be seen in (8) that, given g,R&D expenditure xm is always falling in τ . Substituting (6) and (8) into (4),optimal Northern export profits can be derived:

πnm∗(τ) = (1 − τ)2

4 − g. (9)

Notice that as there is no exposure to imitation, Northern profits are in-dependent of the Southern IPR regime β. Profits clearly fall with a highertariff rate.

In the third stage, which is only relevant if the Northern firm decidesto export, the Southern government chooses an optimal tariff that maxi-mizes Southern welfare under exports Wm.16 Welfare consists of Southernconsumer surplus under exports Sm and tariff revenue T that comes froma unit tax levied on all imported good. The problem for the South is

Maxt

Wm = Sm + T , (10)

where Sm is found by replacing the anticipated monopoly quantity producedby the North in (1) giving17

Sm = 2(1 − τ)2

(4 − g)2. (11)

15 This allows us to set (A − α) to unity as (A − α)2 appears in all relevant equations.16 While tariffs are left more flexible for use as countermeasures within the WTO, theTRIPS framework works with a more rigid mechanism and binds all member nations toa minimum level of IPR protection. The timing of the trade policy in this paper reflectsthis nature of TRIPS. It also prevents the South from practicing a free holiday by enforcinghigh tariffs to induce firms to choose FDI, while using a loose IPR policy to exploit theirtechnology. The latter trivial case is ruled out also because a Northern firm may simplydecide not to serve a country with high tariffs and a loose IPR regime at all.17 Only the final forms of Sm, T, and τ are shown using the optimal R&D investment xm

∗from equation (8).


Consumers always lose when the tariff rate τ increases as both the quantityproduced and the R&D expenditure fall with increasing τ . Yet, the South hastariff revenue T as another source of income which is solved for using qnm

∗as the quantity imported:

T = tqnm∗ = 2τ(1 − τ)

(4 − g). (12)

Tariff revenue increases directly with increasing τ and falls indirectly dueto the cut back in production caused by a higher τ . T reaches its maximumlevel at τ = 0.5. The first order condition of Wm with respect to τ gives theoptimal tariff τ∗ in terms of g:

τ∗ ={

2−g2(3−g) for g ≤ 2

0 for g > 2. (13)

When g is zero, the optimal tariff is at its highest value of 1/3 as the tariffrevenue portion of welfare dominates consumer surplus in less R&D inten-sive industries. The optimal tariff decreases as g increases until it reacheszero at g = 2. Free trade is the optimal trade policy for high R&D efficiencylevels of g ≤ 2.18

Substituting the optimal tariff for τ in (9) we can now derive the optimalprofits of the Northern firm in case of exports:

πnm∗ =

{4−g

4(3−g)2 for g ≤ 21

4−g for g > 2. (14)

Notice that the Northern firm chooses between exporting and FDI by an-ticipating τ∗.19 The optimal tariff is set to maximize national welfare inthe South and tariffs above this level are never chosen as they only reduceSouthern welfare.

The next section discusses the FDI alternative, which the Northern firmmust compare with the export option to decide how to serve the Southernmarket.

18 Trade costs can also be treated as exogenous in the model as the notion of the resultsremains the same. For 0 < g ≤ 1.5 the optimal FDI inducing level of IPR protection de-creases with higher trade costs and to a lesser extent the higher is R&D efficiency. Also formore R&D intensive industries of g > 1.5 the outcome is the same as the desire for inno-vation is the decisive factor in determining the IPR policy.19 The Northern firm is fully aware of the optimal tariff rate; thus, any tariffs other thanτ∗ are not credible.


3.2 FDI

Avoiding trade and transport costs is one of many motives for the Northernfirm to establish local subsidiaries to serve its foreign markets. This paperlooks at FDI as a way to save on trade-costs, which must be weighed againstthe losses from imitation that could follow the relocation of production.20 Inmost developing countries, access to technology occurs mainly by means ofFDI channels of diffusion rather than through domestic innovation (Com-mission on Intellectual Porperty Rights 2002). Once production is movedto the South, basic production technology can be gained. When patentsare binding, however, the cost-reducing technology instigated by NorthernR&D is not fully exposed to the South. A looser IPR regime allows moreknow-how to be disclosed to the Southern firm and lowers the costs ofproduction for the latter.

3.2.1 Duopoly

The Southern firm competes to serve the market if profitable. This creates anasymmetric duopoly situation (except when β = 1) due to cost asymmetriesresulting from the enforcement of IPR. In other words, IPR protectionprevents the Southern firm from fully utilizing the cost-reducing R&Dinvented by the Northern firm. The optimal R&D investment is found fromthe first order condition of the Northern firm’s profit function using (7a) toreplace for output:

xf∗ = g(2 − β)2

[9 − g(2 − β)2]2. (15)

It is easy to see that R&D is lower for looser levels of IPR protection as∂xf ∗/∂β < 0. The optimal profits for the Northern firm in an FDI duopolysituation are obtained by replacing (7a) and (15) into the profit function (4)to get:

πnf∗ = 1

9 − g(2 − β)2. (16)

Equation (16) shows that except for g = 0 where no R&D takes place,Northern profits are always falling in β. The β at which FDI profits intersect

20 Fixed FDI costs are left out while solving the model. Adding fixed costs would only re-inforce the results by linearly decreasing FDI profits. This makes exporting more attractiveand decreases the maximum β at which the Northern firm would undertake FDI.


export profits can be found by setting (14) equal to (16) and solving for β:

β∗ = 2 −(

15 − 4g

4 − g

)1/2

. (17)

Equation (17) implies that if the level of IPR protection in the South ishigh enough (β < β∗) so that the Northern firm’s losses from spillovers arenot drastic, it chooses FDI as the mode of supplying the Southern market.However, for looser IPR regimes (β > β∗), it keeps production in the Northto protect the dissemination of its technology. β∗ = 0.064 when g is zeroand increases with R&D efficiency as the impact of the latter on profits ismuch stronger at lower β’s, where the Northern firm can take full advantageof its own R&D. The rise in β∗ is however relatively small as the optimaltariff rate decreases with a higher g at the same time making exports moreattractive. β∗ eventually reaches its highest level, which is only 0.129, wheng = 2.

Once FDI has been carried out, profits of the Southern firm in a duopolyare

πsf∗ = [3 − g(1 − β)(2 − β)]2

[9 − g(2 − β)2]2. (18)

Southern profits are increasing in β as higher spillovers lead to lower pro-duction costs. Setting expression (18) to zero helps us derive the criticalvalue of β for each g under which it is no longer profitable for the Southernfirm to enter the market:

β̂ = 3 − (1 + 12/g)1/2

2. (19)

β̂ is zero for g = 1.5 and increases thereafter as a higher R&D intensitymakes it more difficult for the Southern firm to compete in the market.At lower efficiency levels of R&D (g < 1.5), it is always profitable for theSouthern firm to enter the market.

3.2.2 Strategic Predation

If the Northern firm finds it optimal to deter entry to the market, it can attaina constrained monopoly position by choosing a predatory level of R&D thatmakes it unprofitable for the Southern firm to produce and compete. Setting


qsf in (7b) equal to zero and solving for x,

xp∗ = 1

g(1 − 2β)2(20)

is the R&D investment that achieves strategic predation with p denotingpredation.21 The predatory level of R&D is much higher than that underFDI duopoly or export. This makes strategic predation a profitable optiononly when the efficiency of R&D is high enough and if the firm’s technologyis highly protected. In contrast to the duopoly case, here R&D investmentincreases with higher imitation, i.e., lower IPR protection levels. Zigic (1998)interpreted this perverse result as a need for higher R&D efforts to force theSouthern firm out of the market when there are higher spillovers since thegap between the Northern and Southern unit costs is smaller. Profits of theNorthern firm when it deters entry to the market is

πnp∗ = g(1 − β)2 − 1

g(1 − 2β)2. (21)

Strategic predation profits are decreasing in β for g ≤ 2. Comparing (16)and (21) yieldsπnf

∗ ≥ πnp∗ showing that the Northern firm unconditionally

prefers to engage in duopoly when the latter is a possible outcome. Profitswith strategic predation are only equal to duopoly profits at β̂ for g ≥ 1.5,which is exactly the point where the Southern firm exits the market andduopoly is no longer viable.

3.3 The Multinationalization Decision and Market Structure

With duopoly as the preferred market structure under FDI, the problem ofthe firm for g < 1.5 is simply to observe the IPR regime in the South anduse β∗ to decide between securing a monopoly position by exporting orengaging in duopoly by undertaking FDI.

For g ≥ 1.5 on the other hand, the value of β determines the marketstructure under FDI. When β ≤ β̂, strategic predation is the only alternativeto exports as duopoly is not a feasible option. Hence, in order to choosethe mode of supply the firm compares export profits to (21). The critical

21 The optimal R&D investment levels under FDI are similar to those obtained in Zigic(1998) in the case of duopoly and strategic predation.


level of IPR protection that makes profit under exports equal to that withpredation is

β∗∗ = g(2 − g)(7 − 2g) − (3 − g)[g(2 − g)(10 − 3g)]1/2

2g(g2 − 5g + 5). (22)

FDI is chosen and followed by strategic predation for β < β∗∗, whereasa higher β provokes the Northern firm to export. For β > β̂ where duopolyis feasible, it is the preferred form of the market under FDI as long as β < β∗,above which exporting dominates.

Figure 2 illustrates how the Northern firm makes its choice on themode of supply and the market structure using two variables: the R&Defficiency parameter and the IPR policy, set by the Southern government inthe first stage. Notice that for 1.5 ≤ g < 1.81, β∗∗ lies above the predationregion implying that when FDI with strategic predation is feasible, it alwaysdominates the export option. In this case β̂ determines the market structureunder FDI, while β∗ is the dividing line between FDI and exports. Forg ≥ 1.81 on the other hand, β∗ falls below β̂ indicating that duopoly isnever chosen when it is an option as exporting always brings higher profits.For this range of g, β∗∗ is the only binding threshold value of IPR protectionthat determines the decision between exporting and FDI.

Figure 2: Northern Firm’s Multinationalization Decision


PROPOSITION 1: For 0 < g ≤ 1.81, the Northern firm protects its technologyby choosing to export when β > β∗ and undertakes FDI for more stringentIPR regimes of β < β∗. Once FDI is carried out, it deters entry to the marketif β ≤ β̂. For more technology intensive industries of 1.81 ≥ g ≥ 2, FDI isalways accompanied by entry deterrence and only preferred to exports whenβ < β∗∗.

We now turn to Section 4 to show how the Southern government canstrategically act to bias the multinationalization decision of the Northernfirm in its own favor.

4 IPR Policy in the South

In the first stage of the game, the Southern government maximizes welfare bychoosing an optimal level of IPR protection strategically. Unlike previousliterature, the policy is endogenous. The government takes the Northernfirm’s reaction into consideration when choosing its IPR regime and caninfluence the market structure.

Southern welfare under FDI consists of consumer surplus, plus theprofits of the Southern firm in the case of duopoly:

Wf ={

Sf + πsf for duopoly

Sp for strategicpredation. (23)

Consumer surplus can be calculated for each scenario under FDI by sub-stituting the corresponding outputs back into (1). This is shown in (24)and (25) for duopoly and strategic predation, respectively:

Sf = [6 − g(2 − β)(1 − β)]2

2[9 − g(2 − β)2]2, (24)

Sp = (1 − β)2

2(1 − 2β)2. (25)

As duopoly was shown to be the only possible FDI market structure forg < 1.5, the sum of (18) and (24) determines Southern welfare for this rangeof g. The term ∂Sf /∂β < 0 suggests that, unlike Southern profits, consumersurplus in the South falls with looser IPR protection when duopoly is theprevailing form of competition. This is directly related to the Northernfirm investing less in R&D and producing less as β increases. The Southern


firm’s profit and thus the desire for imitation dominates Southern welfareat low g’s, causing total welfare to rise with β. As R&D intensity increases,the magnitude of the consumer surplus loss caused by a higher β increases,giving innovation more significance in Southern welfare.

Things are different for g > 1.5 as strategic predation is a feasible out-come for β ≤ β̂. The term ∂Sp/∂β > 0 shows that consumer surplus andhence welfare now increase with looser IPR protection as the latter raisesR&D efforts. The threshold value of β where the Southern consumers areindifferent between duopoly and strategic predation is β̂ where the R&Dinvestment, consumer surplus, and Southern welfare are at their maximumattainable level. It is the highest β at which the Northern firm adopts strate-gic predation and at the same time the lowest β under duopoly that justdrives Southern profits to zero. We are now in a position to solve the modelfor the optimal level of IPR protection from a Southern perspective, fordifferent levels of R&D efficiency.

4.1 Low R&D Efficiency

Comparing welfare under exports and FDI reveals that Wf > Wm alwaysholds for g < 1.5. Since the South is better off with FDI in this range of g,its government must play strategically to induce FDI in order to maximizewelfare. As the Northern firm enjoys a credible threat of exporting forweak IPR protection levels of β > β∗, the South forgoes its first-best weakIPR regime to motivate technology transfer. It sets the lowest level of IPRprotection, which still persuades the Northern firm to engage in FDI. Theoptimal IPR regime gives β∗, which starts at approximately 0.06 for g’s justover zero and increases at a slow rate to only 0.1 as g approaches 1.5. Notethat the South gains from this strategic move even if the required level of IPRprotection is very strong. Figure 3 illustrates Southern welfare for FDI giventhe optimal IPR regime, and for exports given the optimal tariff rate. Ourresults for low R&D intensive industries are different from those obtained inprevious strategic literature, where legitimate means of technology transferwere absent and the South was always worse-off by protecting IPR.

PROPOSITION 2: In less R&D intensive industries (0 < g < 1.5), the Southalways chooses a stringent IPR regime to induce foreign investment as a channelof technology transfer. The optimal level of IPR protection is β∗ in this rangeand is the weakest level of IPR protection at which the Northern firm stillchooses to proceed with FDI.


Figure 3: Southern Welfare

4.2 High R&D Efficiency

In relatively more technology intensive sectors of g ≥ 1.5, entry deterrenceis the only feasible form of FDI for β ≤ β̂ as the Southern firm does notfind it profitable to enter the market. As Wp > Wm always holds, Southernwelfare with FDI dominates that under exports even when the Northernfirm adopts strategic predation. In fact, Wp > Wf indicates that for β > β̂,where duopoly is feasible, the South always prefers constrained monopolyto duopoly under FDI. This is due to the large amount of innovation thattakes place by the Northern firm in the case of strategic predation as anattempt to block entry into the market. However, this is in conflict with theinterests of the Northern firm because it can achieve higher with a duopolywhen β > β̂. The South must therefore set a sufficiently strong IPR levelof β̂ or below to prevent duopoly from being a viable outcome. Since Wp

is increasing in β and β̂ is the minimum protection needed for strategicpredation to occur, β̂ is the most favorable IPR regime for the South. Insum, the optimal IPR regime in this range of g is set to stimulate innovationby inducing strategic predation.

For g ≤ 1.81, the Southern government can set β̂ to induce strategicpredation over duopoly as β̂ < β∗∗ in this region. The latter inequalityimplies that Northern FDI profits at β̂ exceed its profits under the export


option. The optimal IPR level for 1.5 ≤ g ≤ 1.81 is hence β̂, which is 0 forg = 1.5, rising to 0.11 where it reaches its peak at g = 1.81. For g > 1.81 onthe other hand, the Northern firm would export if the South uses β̂ as itsIPR regime because β̂ > β∗∗ for high levels of R&D efficiency. As a result,the South must increase protection up to the threshold value β∗∗, whichmakes the strategic predation profit of the Northern firm equal to that underexports. This switches the optimal policy to β∗∗, which is 0.11 at g = 1.81and is falling in g to match the export profits. Recall that exports becomemore attractive as g increases due to τ∗ getting closer to zero. Ultimately β∗∗reaches zero at g = 2, where only full IPR protection can assure FDI.

The right hand side of Figure 3 shows Southern welfare under predatoryFDI using the optimal IPR level that corresponds to each of the above twohigh R&D efficiency zones. Welfare is always higher when the Northernfirm is induced to engage in FDI along with strategic predation. Higherinnovation activity that takes place to deter entry to the market proves tobe the motive behind protecting IPR in more technology intensive sectors.

PROPOSITION 3: In more technology intensive industries (1.5 ≤ g < 2) theSouth always sets a strict IPR protection regime to stimulate innovation byencouraging the Northern firm to engage in a predatory level of R&D. β̂ is theoptimal IPR protection policy for g ≤ 1.81 as it is the highest β sufficient toinduce FDI over exports, and strategic predation over duopoly. An even higherlevel of protection β∗∗ is required to motivate predatory FDI over exports forg > 1.81, where exports become more attractive as R&D intensity increases.

It is helpful to look at Figures 2 and 3 simultaneously to see that settinga β above the β∗ curve in Figure 2 makes Southern welfare in Figure 3 jumpfrom the FDI curve to the export curve. Choosing a β below β∗ on the otherhand slightly shifts the FDI welfare curve downward, while it always remainsabove the export curve. For a direct comparison of the model with Chin andGrossman (1990), the range of policy set by the North can be restricted tothe two choices of β = 0 and β = 1. The South would never strictly preferno protection to full protection in the presence of technology transfer. Thegeneral results are also consistent with Markusen (2001), which shows thatif contract enforcement leads a multinational to shift from exporting toproducing inside the host country, both the multinational and the hostcountry are better off. The small, yet positive, β derived as the optimal IPRpolicy in the South is also in conformity with Connolly and Valderrama(2005) that a stronger IPR policy, is also in favor of the South, with Lai


and Qiu (2003) that the IPR in the South is naturally weaker than thatin the North, and with Giannakas (2002) that although TRIPS involvesa significant degree of commitment the enforcement is not complete.

An important point to highlight is that our results on the Southernoptimal IPR level are robust to a setting with multiple Southern firms.More firms in the South increase the relative advantage of spillovers, hencecreating incentives for a lower IPR regime to enjoy imitation. However,a weaker IPR regime still induces the Northern firm to export. This elimi-nates the possibility of technology transfer altogether making opportunitiesthat higher spillover levels can bring for the South unfeasible. In fact, a largernumber of firms in the South reduces the attractiveness of FDI due to highercompetition and a bigger loss from imitation, requiring an even strongerIPR policy for FDI to take place. As a result, the optimal IPR in the Southregime remains at least as strong as the above results.

Finally, very high R&D efficiency levels of g > 2 resemble results ob-tained in Zigic (1998). As β̂ > β∗∗ in this region, duopoly is never a viableoutcome and strategic predation profits never exceed export profits at thenow optimal free trade policy. Only at a knife-edge case of β̃ = 1 − 2/g prof-its under strategic predation match what the Northern firm would earn byexporting. Any policy slightly stricter or weaker than β̃ leads the Northernfirm to export. The South is itself indifferent between strategic predationand monopoly export at β̃ as welfare is similar under both market struc-tures. It can be concluded that in industries where R&D plays a vital role,a firm would never risk moving its facilities to the South regardless of theprevailing level of IPR protection there.

5 Conclusion

This paper uses the welfare implications of protecting IPR in developingcountries to show that when technology transfer considerations are ac-counted for, it is not rational for governments in these countries to opposeIPR protection. It attempts to build a more complete model to encompassthe credibility aspect of the TRIPS agreement and include other impor-tant IPR-related factors next to innovation such as FDI and trade policy.While the basic structure used in the model is fairly simple, it generatesa set of noteworthy policy implications for the less developed members ofthe WTO with regards to the TRIPS agreement and technology transfer. Asthe Southern government sets the IPR protection level before the North-


ern firm makes its multinational decision, it can influence this choice byinducing technology transfer or encouraging innovation. In relatively lowtechnology intensive industries, attracting foreign investment as a channelof technology transfer is the motive behind protecting IPR. The level ofprotection is chosen such that exporting is never strictly preferred to FDI bythe North. Although the South may desire a lower level of IPR protection toreach its first-best welfare, the Northern firm’s credible threat of exportingrather than undertaking FDI restricts the latter to a stricter IPR regime.This new contribution to the strategic IPR literature shows that even at lowlevels of R&D efficiency the interests of the North and the South can be incongruence simply because of the Southern need for foreign investment.

For more R&D intensive industries, innovation as opposed to tech-nology transfer is the key concern for protecting IPR in the South. TheSouth stimulates innovation by tempting the multinational to deter entryby means of substantial R&D efforts. Although the South does not imi-tate the complex technology to compete with the North, it benefits fromthe enhanced innovation it induces by protecting the IPR of the Northernmultinational. Therefore a rational South would never strictly prefer to vi-olate international IPR, as the optimal level of protection for the South isalways very high. Endogenizing the decisions of both sides highlights theneed for IPR protection in the South if it were to enjoy sufficient levels ofFDI and innovation.

A possible extension of the model could be to follow the argument inGlass and Saggi (2002) and make imitation costly. This requires the Southernfirm to engage in imitation R&D to be able to utilize Northern innovationR&D. The Southern firm then undertakes own R&D activity, even in theabsence of an IPR protection policy, to be able to take advantage of the cost-reducing technology of the competing firm. This setting could describeemerging markets with limited R&D capacity as opposed to less developedcountries incapable of engaging in any R&D activity. Another interestingline of research would be to examine the decision of multinationals once theydecide to transfer their technology to the South. This could for instance bea choice between FDI and licensing, each of which involves different levels ofspillovers. This can also be extended to allow for the entry of more Southernfirms into the market once the Northern firm has transferred its know-how.In a multi-firm framework, two firms could for instance engage in a jointventure to conceal their technology from outsider Southern firms.

This paper only considers the indirect trade impact of IPR protection forthe South. Direct trade impacts are not considered as this model assumes


that the Northern firm always serves the Southern market as long as thereis demand, and has only to choose the channel of transfer.22 It also ignoresother important criteria that may reinforce or rule out the suitability forinclusion of IPR in the WTO such as international externalities, policycoordination failures, and meaningful dispute resolution. Analyzing thesecriteria shows that IPR may indeed have a stronger case for standardizationthan other fields such as competition policy, environmental protection, andlabor standards (Maskus 2000b). This paper attempts to make obvious theimportant role that policy choices of governments in the South play intheir welfare when confronting a profit-maximizing multinational whoseprofits and therefore actions are directly based on these policies. It showsthat multinationals have the power to avoid global dissemination of theirtechnology. Therefore nations seeking to gain access to new technologies orsimply to a larger amount of the commodities containing them must paythe cost and protect IPR in order to promote growth by inducing FDI andcreating the incentives to innovate.

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