Technology Spillover and Export-Platform FDI

Transcription

1 Technology Spillover and Export-Platform FDI Arghya Ghosh, Hodaka Morita and Xuan T. Nguyen School of Economics Australian School of Business University of New South Wales June 1, 2010 Abstract This paper explores optimal Intellectual Property Right (IP R) policy for a Southern country which hosts Export-Platform F DI (EP F ) undertaken by a Northern firm (firm N). We develop a duopoly model in which firm N competes with a Southern firm (firm S) in Southern market and a third-country market, and where firm N has superior technology. A loose IP R policy is represented by a high level of technology spillover from firm N to firm S that reduces the later s marginal cost. We demonstrate that (i) EP F improves Southern welfare, and (ii) upon EP F, loose IP R policy benefits Southern firm and Southern consumers. Hence, the South always has incentive to choose an IP R policy which is just loose enough to make EP F attractive. In this context, we examine the impacts of increasing market size and trade libralization between the South and third country on optimal IP R policy for the South and market structure. JEL classification: F12, F1, F15, F21, L12, L1 We wish to thank Russell Hillberry, Yusaku Horiuchi, Jota Ishikawa, James Markusen, Kamal Saggi, Yi Jin and participants of Japan-UNSW Applied Microeconomics Workshop 2009 at University of New South Wales, Australasian Economic Theory Workshop 2010 at University of Melbourne, and Australasian Trade Workshop 2010 at Australian National University for their helpful comments and suggestions on earlier versions. Contact: School of Economics, Australian School of Business, University of New South Wales, Sydney 2052 Australia. contact for Arghya Ghosh: A.Ghosh@unsw.edu.au; Hodaka Morita: H.Morita@unsw.edu.au; Xuan T. Nguyen: Xuan@unsw.edu.au. i

2 Ghosh, Morita, and Nguyen (2010) 1 1 Introduction As documented by UNCTAD (2005), not only being stimulated by market-seeking activities, foreign direct investment (F DI) has also been driven by export activities. Many multinational companies (MNCs), headquartered in Northern countries, have recently shifted their production from home to a Southern country and use Southern production as platform to export their products to other countries. This situation is often referred to as Export-Platform F DI (EP F herein after) in the international trade literature (e.g, Ekholm, Forslid, and Markusen 2007). In this literature, the main driving force for EP F typically comes from locational cost-advantages of the country that hosts EP F, which comprise of (i) productioncost advantage, in particular low labor cost, and (ii) transaction-cost advantage, which is the result of some bilateral (or regional) trade agreements between the country that hosts EP F and the export markets of the MNC. In this respect, F DI in automobile industry in Argentina and Brazil was mainly for export to Mexico thanks to the bilateral agreement between Mercosur member countries and Mexico (UNCTAD, 2005). Similarly, Japanese manufacturing firms view ASEAN member countries as good places to invest in order to export to other ASEAN countries (JETRO, 2008). 1 F DI often brings about several benefits for the host countries. For instance, it generates tax revenue for the government from value-added, creates jobs and helps to transform production in host countries toward modernization with technology transfer (UNCTAD, 2002). In recent years, more emphasis has been placed on the role of technology transfer. Many Southern countries have become active in seeking F DI into industries that have export potentials but local firms need to learn advanced technologies from foreign firms. This gap in technology is driven by the fact that advanced technology often comes at extensive R&D investment that only firms in developed country could afford. 2 In combination with a weak Southern Intellectual Property Rights (IP R) regime that does not fully protect foreign technologies upon F DI, this policy has enabled local competing firms to learn the performance of the foreign firms and eventually compete with foreign firms in their export markets. In other words, local firms could benefit from technology spillover from foreign firms upon EP F, which explains the movement of Southern countries toward encouraging EP F. Chinese government s F DI policy in automobile industry is an example for the combination of inducing both EP F and technology spillover in reality. The inclusion of foreign companies in Chinese automobile industries, as targeted by Chinese government in its 1994 China Automotive Industry Policy, should aim to create technology transfer to local automakers, and expand exports (Long, 2005). After nearly two decades, this policy has been 1 JETRO s survey conducted in 2007 detailed that Japanese-affiliated manufacturing firms undertaking F DI in ASEAN countries have exported between 21.4% and 45.% of their output to ASEAN region (excluding sales in the country they invest). Xuan and Xing (2008) tested the gravity model for Vietnam and found strong correlation between FDI and export. 2 Keller (2004) demonstrated that, most of world s creation of new technology are concentrated on a few rich countries.

3 Ghosh, Morita, and Nguyen (2010) 2 successfully implemented in practice, with Chinese automakers beginning to export cars to the world market. What often observed in reality was that, Chinese car manufacturers learned advanced techniques from foreign firms, mainly through labour mobility (Luo, 2005 and Gallagher, 200). The benefit through learning, often referred to as technology spillover, was partly pushed by Chinese government through its F DI policy in which it asked foreign automakers to share their technology with local partners. Eventually, as Japan and U.S. manufacturers, including Honda, General Motors and Detroit, exported cars from China to other countries since early 2000s, many local Chinese automakers also started to export Chinese-made cars. 4 Export-Platform F DI induces technology spillover that enables local firms to export has also been witnessed in many different industries in several countries. In India, the software industry could not have been so well developed without investments of U.S. multinationals. As documented by Bhatnagar (2006), and Pack and Saggi (2006), U.S. multinationals mostly used India as an export platform. Many local Indian firms have acquired the knowledge necessary to produce export-quality softwares mainly from recruiting engineers with experiences with U.S. software firms (both from the U.S. Silicon Valley or engineers come with U.S. multinationals to Bangalore). Consequently, as U.S. multinationals increased their export volume to over 60 countries from Indian affiliates, local firms also catch up quickly (Millar, 2000 and Bhatnagar, 2006). Currently, local firms account for 75% of software export from India. As suggested by above examples, in the presence of technology spillover, different countries adopt different IP R regimes to induce EP F by Northern firms. What is the optimal IP R policy should a Southern government choose in order to maximize the benefits of EP F? In other words, does the South benefit from protecting IP R? How does IP R protection in the South affect Northern firms? How does preferential trade liberalization between the South and third-country affect Southern IP R policy and third-country market structure? This paper attempts to address above questions by exploring an North-South duopoly model with technology spillover. In our set-up, a Northern firm (firm N) and a Southern firm (firm S) compete in Southern market and a third-country market in a Cournot fashion. Firm N can locate itself at home (HP ) or undertake EP F in the South, while firm S is located in the South only. If firm N locates itself in the South (EP F ), it can avoid trade costs of exporting its product to Southern market. At the same time, as we investigate the of implications of trade liberalization between the South and third country, we will assume that trade cost between the South and third country is lower compared to that between the North and the third country (see more below). Therefore, firm N also saves on trade costs China only allows foreign automakers to set up joint ventures with domestic firms as the mode of entry, rather than operating wholly foreign owned company so that foreign firms need to transfer their technology to Chinese partners (Long, 2005 and Luo, 2005). 4 For instance, Chery exported around 50,000 cars in 2006 and 119,800 cars in Source: htm.

4 Ghosh, Morita, and Nguyen (2010) of serving third-country market if it undertakes EP F. 5 However, technology spills over from firm N to firm S under EP F and intensifies competition between them in both markets under a range of parameterizations. With the model presented above, we find that, EP F undertaken by firm N improves Southern welfare. At the same time, since a loose IP R environment benefits both firm S and Southern consumers, the South has incentive to choose the highest possible level of spillover rate that still induces EP F. We show that, when the Southern market becomes larger, it tends to provide looser IP R protection with EP F. Finally, we demonstrate that the presence of third-country market makes EP F more attractive in case trade is liberalized between the South and the third country. This leads to the South becoming more reluctant to strengthen its IP R policy at the successful negotiation of a trade agreement with the third country (export market). There has been a growing number of studies that address EP F in trade literature. Most previous papers focused on the strategic choice of Northern firms between export, F DI, and EP F based on differences in production costs and tariff rates between countries (Ekholm et al, 2007 and Motta and Norman, 1996). In these papers, however, there is no technology spillover. In contrast, EP F has not yet been examined in technology spillover literature, which so far has concentrated mainly on how a Northern firm, which has superior technology compared to its Southern competitor thanks to some R&D investment, reacts to IP R regimes in the South (Chin and Grossman, 1990 and Zigic, 1998). Loose IP R regime benefits Southern firm who can imitate Northern competitor s technology. Naghavi (2007) augmented this cost-reducing technology spillover framework to investigate the Northern firm s choices between export and F DI. 6 He found that when duopoly is prevailing form of market structure, F DI improves Southern welfare. To the best of our knowledge, however, no previous papers have analyzed the economic impacts of IP R policy in an EP F model with technology spillover, which the present paper attempts to investigate. The rest of the paper proceeds as follows. Section 2 reviews the related literature, followed by a description of the model in Section. Section 4 characterizes SPNEs of the model. Section 5 and 6 explores optimal IP R policy for the South, and the impacts of trade liberalization, respectively. Section 7 provide concluding remarks. 2 The related literature As pointed out by Neary (2002 and 2009), the traditional argument that trade and F DI should be substitute based on the proximity-concentration trade-off (often referred to as tariff-jumping motive of F DI) does not coincide with the huge influx of F DI in many 5 As is illustrated in the subsequent sections, we focus our analysis here forth to the consideration of a bilateral trade agreement between the South and third country. 6 See also Glass and Saggi (2002), and Morita and Nguyen (2010) for related papers.

5 Ghosh, Morita, and Nguyen (2010) 4 European countries in 1990s. That is, even though the standard trade theory predicts that, trade cost reduction between trading partners discourages F DI, in reality, F DI has actually been increased following trade liberalization. To explain this paradox, Neary argued that, intra-bloc trade liberalization has induced foreign firms to establish plants in one country as Export-Platform to serve the bloc as a whole. There are two sources of gain for the foreign firm from EP F : (i) tariff-jumping gain as the host country market is served from local plant, and (ii) trade-liberalization gain if the export market forms trade liberalization with the country that hosts EP F. This argument is supported by real world evidences, especially F DI into the European Union from the U.S. and Japan companies in 1990s (see also Head and Mayer, 2004). Motta and Norman (1996) considered an oligopoly model with three firms, one in country U, one in G, and one in J, where the countries are of equal size and firms are similar in all respects. The authors focused on market U and market G only. They showed that, a regional trade-agreement between U and G will induce the outsider firm (from J) to undertake EP F in either U or G. If trade liberalization is great enough, the gain from consumer surplus as a result of price reduction under EP F outweighs the loss in domestic firms profit resulting from increased competition, suggesting EP F improves total welfare for U and G. They also demonstrated that U and G could gain more by liberalizing trade between these two countries to induce EP F rather than coordinating for a tougher common external trade policy. This result captures the gains accrued to member countries in EU, NAFTA, and ASEAN following regional trade liberalization. In a recent work along this line, Ekholm et al (2007) developed a duopoly model with two symmetric Northern firms from countries W and E serving consumers in their home country and the rival s country. There is a third country, country S, serving purely as a production platform, where production cost is lower compared to W and E. They found that, when trade costs between any two countries are the same and production costs in S are low enough, both firms from W and E pursuit a global Export-Platform strategy in which they manufacture all products in S and export to W and E. When countries S and W form a free trade agreement and production cost saving in S are modest, both firms have a plant in S to serve consumers in country W, and they both have a plant in E to serve consumers in E. That is, outsider firm undertakes EP F. The authors argued that, this framework explains the tendency of U.S. multinationals in their overseas factories toward EP F, especially U.S. affiliates in North America and Europe. How is F DI related to technology spillover? Saggi (2002) argued that, firms undertaking F DI often have superior technology compared to competitors in host countries, and F DI often comes with international technology transfer. How well a developing country can take advantage of technology transfer from F DI depends on several factors, including the protection it offers for intellectual property rights. Along this line, there has been an increasing number of papers that examine the relationship between trade and F DI in an environment where technology spills over from foreign to local firms. In a seminal contribution to technol-

6 Ghosh, Morita, and Nguyen (2010) 5 ogy spillover literature, Chin and Grossman (1990) developed a Cournot duopoly model in which a Northern firm competes with a Southern firm in an integrated world market where only Northern firm can invest in R&D. By investing in R&D, Northern firm s marginal cost becomes lower. However, Northern firm s technology can be imitated by a Southern competitor if Southern IP R regime is loose. Zigic (1998) extended this framework and introduce a continuous spillover parameter, which represents the level of IP R protection in the South. These authors found that, if duopoly is the prevailing form of market structure, loose IP R regime tends to improve Southern welfare. Naghavi (2007) augmented the above cost-reducing technology spillover framework by focusing on Southern market and examining Northern firm s choice of modes of entry into Southern market between export and F DI. He found that F DI improves Southern welfare when duopoly is the prevailing form of competition. Under a slightly different approach, Glass and Saggi (2002) considered an international duopoly model where technology spillover from source firm to host firm upon F DI can be prevented by a wage premium. 7 They showed that, even when competition takes place in a different country, F DI improves host country s welfare because of the benefits accrued to either the host firm or workers upon F DI. Morita and Nguyen (2010) explored consequences of technology spillover that is accompanied by a Northern firm s F DI in the South and either enhances product quality or reduces marginal cost for a local competitor. In the case of cost-reducing technology spillover, Northern firm can choose any level of marginal cost for its product, while Southern firm can only choose marginal cost level above some threshold value. This value becomes lower when Northern firm undertakes F DI in the South thanks to the impacts of technology spillover. They demonstrated that, F DI improves Southern welfare. Furthermore, since an increase in spillover rate under F DI increases Southern welfare, the Southern government should choose the highest possible value for spillover rate that still induces F DI. To the best of our knowledge, no previous papers have incorporated technology spillover into an EP F framework, which the present paper attempts to address. We demonstrate that, with the presence of technology spillover, EP F still improves welfare for the host country compared to home-production under a range of parameterizations. The impacts of regional trade liberalization between the South and third country on post-equilibrium market structure is also examined along this line. The model We consider an international duopoly model with two firms, a Northern firm (firm N) which has headquarter in the North, and a Southern firm (firm S) which has head quarter in the 7 In Glass and Saggi (2002), technology transfer through labor mobility. When the source firm undertakes F DI, its workers can switch to work for a local competing firm. To prevent this, the source firm can pay a wage premium to retain workers.

7 Ghosh, Morita, and Nguyen (2010) 6 South, both producing a homogeneous good. To capture what often happens in reality, we assume that firm N can locate itself in the North (home-production, denoted HP ) or in the South (F DI), while firm S can locate itself in the South only. Furthermore, firm N has superior technology compared to firm S, which leads to firm N s marginal cost being lower than that of firm S. To simplify the analysis, we assume that without technology spillover, firm N s marginal cost is zero, while firm S s marginal cost is equal to c(> 0). 8 Fixed costs are assumed sunk to simplify the analysis. Technology spillover in our model works in the following manner. If firm N locates itself in the North (HP ), there is no technology spillover. If firm N locates itself in the South (F DI), its technology spills over to the firm S, which lowers the marginal cost of firm S by an amount equal to βc, where β( [0, 1]) is a parameter representing the rate that technology spills over, which often captures the degree of IP R enforcement in the South (see more on this set up in Morita and Nguyen, 2010). That is, if firm N undertakes F DI, firm S s marginal cost is c = (1 β)c. At its extreme values, β = 0 represents the case firm N s technology is fully protected in the South so that firm S s marginal cost remains at c even if firm N undertakes F DI; and β = 1 represents the case firm S can fully copy firm N s technology upon F DI so that its marginal cost is zero upon firm N s presence in the South. Consumers are located in the South (market S) and a third-country (market T ). Trade costs between any two countries are represented by specific tariff rates. Let t 1, t 2, and µ, respectively, be the tariff rates between Northern country and Southern country, Northern country and third country, and Southern country and third country (see Figure 1). 9 The representative market-s consumer s utility function is given by U S = A(q NS + q SS ) b q2 NS +2q NSq SS +qss 2, and the representative market-t consumer s utility function is given by 2 U T = B(q NT + q ST ) q2 NT +2q NT q ST +q 2 ST 2. Here, q ij, i (N, S) and j (S, T ), denotes firm i s quantity level in market j, and b(> 0) represents the size of market S - higher b is corresponding to a smaller market size. The representative consumer in market j maximizes U j p j (q Nj + q Sj ), which yields inverse demands for markets S and T respectively as follows: We consider a two-stage game, described below. p S = A b(q NS + q SS ), (1) p T = B q NT q ST. (2) [Stage 1] Firm N chooses its location between HP and EP F. [Stage 2] Firms N and S compete in quantity and consumers make purchasing decision. 8 Alternatively, we can assume that firm N s marginal cost is c(> 0) while firm S s marginal cost is ĉ(> c). However, this does not change the qualitative nature of the results. 9 We ignore the Northern market to simplify the analysis. There are several possible explanations for this exclusion, for instance, consumer characteristics, language barrier, cultural barrier, etc. As an example, Japanese consumers often buy electronic products from Japanese firms, and they rarely buy electronic products with a foreign brand-name.

8 Ghosh, Morita, and Nguyen (2010) 7 Notice that the game described above has two stage 2 subgames, one is HP subgame in which firm N locates itself at home, while the other is EP F subgame in which it locates itself in the South. tt 2 Third country North country μμ tt 1 South country Figure 1: Trade between countries The model described above has three distinctive features comparing to the traditional EP F studies (Ekholm et al, 2007 and Motta and Norman, 1996). First, we focus on competition between a Northern firm and a Southern firm, rather than between two symmetric Northern firms. Second, we introduced asymmetry between firms in terms of technology, that is, firm N has superior technology compared to firm S which shows up in the gap in the firms marginal costs. Finally, we incorporate technology spillover into the model in a similar fashion to Morita and Nguyen (2010). In the subsequent section, we will characterize the Subgame Perfect Nash Equilibria (SPNEs) of the game and elaborate on its basic properties. 4 Analysis Let us now derive Subgame Perfect Nash Equilibria (SPNEs) of the model described in previous section by backward induction. Throughout the analysis, we assume the sizes of market S and T are relatively large so that firm N sells a strictly positive amount of its products in both markets regardless of its location, while firm S always sells a strictly positive amount of its product in its home market. 10 We also focus on the case trade is more liberalized between the South and third country compared to that between the North and third country by assuming that µ < t 2 holds. This assumption helps us to reduce a number of cases to be considered and, at the same time, simplify the comparison of the findings in the present paper with the Export-Platform F DI literature, which also analyzes the impacts of trade liberalization between the South and third country (a reduction in µ). 10 By examining firms N and S s profit functions in each subgame, as shown later, the parameterizations are given by B > max(t 2, µ), and A > 2c.

9 Ghosh, Morita, and Nguyen (2010) 8 In this section, we start to explore subgame equilibria at the second stage, where firms compete in quantities. Then, we investigate firm N s optimal location choice in the first stage. 4.1 Quantity competition This sub-section focuses on the last stage of the game in which firms N and S compete in quantities. Let πi e and π f i be profit of firm i(= N, S) in the equilibrium of HP subgame and EP F subgame, respectively. Hence, πn e is firm N s profit if it exports to both markets with home-production while π f N is its profit upon EP F The equilibrium of HP subgame Let us now explore the equilibrium of HP subgame when firm S chooses not to sell in market T. In this case, firms N and S engage in Cournot competition in market S while firm N is a monopolist in market T, and we call this an HP equilibrium with monopoly, denoted {e1}. In this equilibrium, at stage 2, firm N chooses qns e and qe NT while at the same time firm S chooses qss e. Standard Cournot results give us qe NS = A 2t 1+c, q e NT = B t 2, and 2 qss e = A 2c+t 1. In a similar fashion, consider the equilibrium of HP subgame when firm S exports to market T. In this case, firms N and S engage in Cournot competition in both markets S and T, and we call this an HP equilibrium with duopoly, denoted {e2}. At stage 2, firm N chooses the levels of quantity qns e and qe NT while at the same time firm S chooses qe SS and qst e. The Cournot solutions are given by qe NS = A 2t 1+c, q e NT = B 2t 2+c+µ, q e SS = A 2c+t 1, and qst e = B 2c 2µ+t 2. Firm S s supply strategy under HP subgame is determined as we examine its profit function in market T. For firm S to export, its profit in T must be positive, or the quantity level qst e > 0, which corresponds to µ < B 2c+t 2. By letting µ 2 1 = max(0, B 2c+t 2 ), we 2 formalize this result in Lemma 1. Note that all proofs are presented in the Appendix. Lemma 1. There exists a threshold value µ 1 ( 0) such that in the equilibrium of HP subgame, firm S exports to market T if and only if µ < µ 1. Under HP, an increase in trade cost between the South and third country increases firm S s cost. Consider the case when µ is relatively high, such that firm N can behave like a monopolist in market T choosing qnt e = B t 2 without worrying about firm S s entry. This 2 happens when the residual demands leads to a market price, B+t 2, being lower than firm S s 2 marginal cost, c + µ, so that exporting to market T is not profitable and firm S sells all of its product in its home market. Let us decrease the value of µ. Then, at some certain value, the marginal cost of firm S becomes lower than the market price firm N, as the monopolist, charges consumers in market T. This induces firm S to export to market T. Lemma 1 then tells us that, in the equilibrium of HP subgame, firm S will export its product from

10 Ghosh, Morita, and Nguyen (2010) 9 the South to the third-country market when trade cost between the two countries is small enough The equilibrium of EPF subgame We now turn to investigate the equilibrium of EP F subgame, where firm N undertakes Export-Platform F DI in the South that induces technology spillover. In this case, two possibilities will arise. The first possibility is that firm S runs a negative profit in market T so that it competes with firm N in market S only. We call this an EP F equilibrium with monopoly, denoted {f 1}. The other possibility is that, firm S obtains some positive profit from exporting its products to market T. We call this an EP F equilibrium with duopoly, denoted {f 2}. In {f1} equilibrium, Cournot equilibrium quantities are: q f NS = A+c, q f NT = B µ, and 2 = A 2c ) 2, is decreasing in c, so q f SS. 11 Since profit of firm S in this case, π f S = ( A 2c firm S optimally chooses c = (1 β)c. This implies q f NS = A+(1 β)c, and q f SS = A 2(1 β)c. Similarly, the Cournot solutions under {f2} equilibrium are given by q f NS = A+(1 β)c, q f NT = B+(1 β)c µ, q f SS = A 2(1 β)c, and q f ST = B 2(1 β)c µ. When does {f 2} equilibrium arise under EP F? It follows that firm S exports to third-country market if its profit therein is positive, or q f ST > 0 β > 2c (B µ). Letting β = β(µ) = max(0, 2c (B µ) ) leads to Lemma 2c 2c 2. Lemma 2. In the equilibrium of the EP F subgame: For any given value of µ, there exists a value β(µ)( 0) such that firm S exports to market T if and only if β β(µ), where β(µ) is strictly increasing in µ, and For any given value of β, there exists a value µ(β)( 0) such that firm S exports to market T if and only if µ µ(β), where µ(β) is strictly increasing in β. Lemma 2 says that firm S exports to market T when the level of spillover rate, β, is high enough. This is because an increase in β reduces firm S s marginal cost upon EP F, (1 β)c. If firm N behaves like a monopolist in market T by choosing q f NT = B µ then 2 residual demand leads to an equilibrium price which is independent of β. Hence, for high enough β, firm S s marginal cost becomes lower than this price level, and firm S can make a positive profit from exporting its products to market T. Why is β(µ) increasing in µ?. Assume β is slightly above β(µ) so that firm S makes positive profit if it exports to market T. Then, an increase in µ raises trade cost of serving market T, so that to guarantee firm S s profit from market T being positive, its marginal cost will need to be lower, which can be done by increasing β. That is, higher µ increases threshold β(µ). 11 Morita and Nguyen (2010) established that when firm N undertakes F DI in the South, it always chooses the minimum level of marginal cost, equal to zero, in a similar set up.

11 Ghosh, Morita, and Nguyen (2010) 10 The same logic applies when we fix β and analyze the effects of µ on market structure under EP F equilibrium. Starting with µ = 0 and B is high enough so that q f ST = B 2(1 β)c µ > 0 and firm S makes positive profit in market T. As µ increases, at some threshold value µ, q f ST becomes zero (when qf NT is still positive), and firm S ceases to exist in market T as it makes negative profit if µ becomes greater than this threshold. That is, firm S s entry in market T is guaranteed when µ is low enough. In summary, the analysis concerning quantity competition in the last stage of the game suggests that for any given value of spillover rate (β), if trade cost between the South and third country (µ) is low enough then in the equilibrium of both subgames, market structure is duopoly in market T, and it is monopoly when µ is relatively high. With this result, we are now ready to continue to analyze the equilibrium of the whole game by exploring firm N s location choice in the first stage. 4.2 The location choice of firm N Let us now analyze the first stage of the game to explore firm N s choice of location between HP and EP F. With several parameters given in the model, a number of cases will arise in the equilibrium of the game. In what follows, we focus on the case of B > 2c which makes β(µ = 0) < 0 so that when both β = 0 and µ = 0 hold, firm N undertakes EP F and competition in both markets are duopolistic competition. These cases are depicted in Figure and Figure Let µ 2 = B 2c, Figure captures the case in which µ 2 µ 1, while Figure 4 corresponds to the case in which µ 2 > µ 1. In the first stage of the game, firm N chooses its location between HP and EP F by comparing its profit level in the equilibrium of each subgame. Its location choice, which depends on β, is given by Proposition 1. Proposition 1. There exists a value β ( 0) such that the equilibrium of the game is an EP F equilibrium if β β and it is an HP equilibrium otherwise, where β [0, 1) holds under a range of parameterizations. Furthermore, when β [0, 1), there exists a value β, β β, such that post-equilibrium market structure in third country is duopoly if β [β, β ] and it is monopoly if β [0, β ). {f1} equilibrium {f2} equilibrium {HP} equilibrium ββ = 0 ββ = ββ ββ = 1 ββ = ββ Figure 2: Technology spillover and market structure 12 The analysis of other special cases are available upon request.

12 Ghosh, Morita, and Nguyen (2010) 11 When β = 0 and µ = 0 hold, firm N undertakes EP F since it can avoid trade costs, and the equilibrium of the game is an {f2} equilibrium. In this case, since µ = 0 < min(µ 1, µ 2 ), firm S also sells a strictly positive amount of its products in both markets S and T by Lemma 1 and Lemma 2. Then, an increase in β mitigates firm S s cost constraint. As firm S s marginal cost becomes lower, firm N s equilibrium quantity level decreases while firm S s equilibrium quantity level increases in both markets S and T. Thus it decreases firm N s profitability, π f2 N, and increases firm S s profitability. Since firm N s profit under HP does not depend on β, when the level of spillover rate is high enough, π f2 N < πe2 N holds and firm N switches from EP F to HP. This logic carries over as we analyze the location choice of firm N for all small value of µ satisfying µ < min(µ 1, µ 2 ) (see Figure and 4). Letting β = 0 in this case leads to Proposition 1, which tells us that, the equilibrium of the game is an HP equilibrium if the level of spillover rate is high enough, and it is an EP F equilibrium if the level of spillover rate is low enough. Now to explain the logic behind Proposition 1 for the case of µ min(µ 1, µ 2 ), it is necessary to analyze cases leading to Figure and 4 separately, since they contain different economic implications. ββ 1 {e2} ββ (μμ) {e1} {f2} ββ (μμ) ββ (μμ) {f1} 0 μμ 2 μμ 1 μμ B μμ Figure : IPR policy - trade liberalization, µ 2 µ 1 First, let us consider Figure, where µ 2 µ 1. For any µ [µ 2, µ 1 ], under HP subgame, competition in market T is duopolistic competition since both firms sell strictly positive amount of their products in this market by Lemma 1. Then, for all β < β, the equilibrium of the game is an {f1} equilibrium in which firm S does not export to market T. If β becomes equal or higher than β then firm S begins to export to market T and the equilibrium of the game switches to {f2} equilibrium. What is the impact of a further increase in β? For firm N, higher β makes {f 2} equilibrium become relatively less attractive compared to {e2} equilibrium, since it decreases its profitability. Hence, if β exceeds some value β, firm N switches from EP F to HP. The same logic carries over for the case of µ [µ 1, µ ] in Figure

13 Ghosh, Morita, and Nguyen (2010) 12, at which under HP equilibrium firm S does not export to market T, even though the slope of the boundary line (β ) becomes steeper as µ increases from µ 1 to µ (µ 1, µ ). 1 Finally, for all µ [µ, B], both {e2} equilibrium and {f2} equilibrium cease to exist since too high trade cost between the South and third country does not guarantee a positive profit for firm S in market T. Then, {f1} equilibrium will result for small enough values of spillover rate, and {e1} equilibrium will result for high values of spillover rate. Similar logic applies when we analyze the case leading to Figure 4 (µ 2 > µ 1 ). The only difference is that, the area for {f1} equilibrium shrinks down in this case thanks to the dominance of {f2} equilibrium over {f1} equilibrium for all µ [µ 1, µ 2 ]. With these results, Proposition 1 then tells us that, for any given value of µ, to encourage firm N to undertake EP F, the South should not choose too-high values for spillover rate (i.e., it should not follow too-lax IP R regime), since firm N may switch from EP F to HP to avoid the negative impacts of technology spillover. Note that the threshold value β, which defines post-equilibrium market structure in market T under EP F, could be found from above analysis when we define β = β when µ (µ 2, µ ] and β = β when µ (µ, B). ββ 1 {e2} ββ (μμ) {e1} {f2} ββ (μμ) ββ (μμ) {f1} 0 μμ 1 μμ 2 μμ B μμ Figure 4: IPR policy - trade liberalization, µ 2 > µ 1 With the presence of technology spillover in the South, firm N has to compare the benefits of trade-cost saving upon production in the South and the negative impacts of technology spillover when it chooses the location between HP and EP F. This section has shown that, to induce EP F, the South should pursue a strong IP R protection regime. What level of IP R protection is optimal? We address this question in the subsequent section. 1 The reason is that, under {e1} equilibrium, firm N is the monopolist in market T so that an increase in µ decreases its profitability why it does not harm firm S as in {e2} equilibrium. Then, to make {f2} become relatively attractive compared to {e1} equilibrium, the decrease in β needs to be larger to offset for the loss in firm N s profitability, compared to the decrease in β needed to make {f2} become relatively attractive compared to {e2} equilibrium.

14 Ghosh, Morita, and Nguyen (2010) 1 5 Optimal IPR policy We now turn to explore optimal IP R policy for the South, which is represented by the optimal value of β that maximizes Southern welfare. To fulfill this objective, we will compare the maximum level of Southern welfare under the equilibrium of EP F subgame for all β [0, β ] with that under the equilibrium of HP subgame which does not depend on β for all β (β, 1). Lemma. Under EP F equilibrium, Southern welfare is strictly increasing in β. When β β, the equilibrium of the game is an EP F equilibrium. In this equilibrium, an increase in the value of spillover rate mitigates firm S s cost constraint, so that firm S s marginal cost becomes lower. Let us investigate the case µ [µ, B] so that firm N is the monopolist in market T (β β ). Then, as mentioned earlier, a slight increase in β [0, β ) decreases firm S s marginal cost, leading to firm S s output increasing in the equilibrium of the EP F subgame. This benefits not only firm S but also Southern consumers since the increase in total supply drives down equilibrium price. 14 Hence, the combined impacts of a slight increase in β [0, β ) on Southern welfare, which is simply the sum of firm S s profit and consumer surplus, is positive. Likewise, when µ < µ, for a given value of µ, Southern welfare under {f2} equilibrium is higher than that under {f1} equilibrium by the amount equal to firm S s profit obtained from market T. Therefore, the South strictly prefers β [β, β ] to β [0, β ). Then, again, a slight increase in β (0, β ) improves Southern welfare under EP F equilibrium by similar argument for the case of µ [µ, B]. Meanwhile, a slight increase in β [β, β ) also results in similar effects in market S, and at the same time, it also increases firm S s profit obtained from market T. Hence, an increase in β [β, β ) creates stronger positive impacts on Southern welfare compared to a similar increase in β [0, β ) thanks to additional benefits from market T. Lemma tells us that, under EP F equilibrium, the South should choose the highest possible value of spillover rate (that is, it chooses β = β ). Recall from previous section that, when β exceeds β, the equilibrium of the game switches from EP F to HP. Does an increase in β from β = β to β > β improves Southern welfare? This question is addressed in Proposition 2 below. Proposition 2. Optimal IP R policy for the South is represented by the highest value of spillover rate that still induces EP F by the Northern firm. That is, β = β. Consider a decrease in β from β = β > β to β = β. This switches the equilibrium of the game from HP to EP F. Since under EP F, firm S s marginal cost is lower than that under HP (due to technology spillover) while firm N s marginal cost is exactly same under both subgames, it follows that total supply under the equilibrium of EP F subgame 14 In market S, total supply is given by Q = q NS + q SS = 2A c, which is decreasing in c.

15 Ghosh, Morita, and Nguyen (2010) 14 is higher than that under HP equilibrium. Thus, switching of the equilibrium from HP to EP F not only benefits firm S but also Southern consumers. These are the positive impacts of switching of equilibrium following a large enough reduction in β for the South. However, at the same time, since firm N does not export to market S under EP F, this switching of equilibrium (from HP to EP F ) decreases Southern government tariff revenue to zero. To make the analysis transparent, consider the case of µ [µ, B] so that the switching of equilibrium happens between {e1} equilibrium and {f1} equilibrium. If µ = t 2 then firm N is the monopolist in market T in both HP and EP F equilibria, where it obtains the same amount of profit. In such a case, firm N only needs to weigh the benefits and costs of production in the South versus home production to choose its optimal location. Morita and Nguyen (2010) established that in such a case (without market T ), following switching of equilibrium from HP to EP F (corresponding to switching from {e1} to {f 1} equilibrium), the total gains of firm S and consumers from firm N s production in the South outweighs the loss in tariff revenue, hence, Southern welfare improves when firm N undertakes F DI. In the presence of market T and µ < t 2, production in the South becomes even more attractive for firm N, which means that it is willing to undertake EP F even for slightly higher value of β, (but still we need that β β ). Hence, Southern welfare even improves further. In case µ < µ, starting with relatively high value of β so that HP equilibrium results. Then, a large enough reduction in β may switch the equilibrium from either {e1} or {e2} equilibria to {f 2} equilibrium. Then, since under {f 2} equilibrium, firm S could make some positive profit from exporting to market T, this equilibrium is strictly preferred to by the South over the {f 1} equilibrium, all else equal. Hence, switching of equilibrium from HP equilibrium to {f 2} equilibrium raises Southern welfare. That is, the benefits for the South could be amplified by firm S s ability to enter market T. In any of above cases, switching of equilibrium from HP to EP F improves Southern welfare, Then, with the help of Lemma, it is clear that, the South should choose the highest possible value of β that still induces EP F. This leads to Proposition 2, which tells us that to maximize Southern welfare, the social planner should choose an IP R policy which is just loose enough to encourage EP F. This optimal IP R policy is represented by β = β. We next explore the impacts on optimal IP R policy in the South of an increase in its home market size - that is, we undertake comparative statics concerning parameter b (on β (b)). Recall that, with the demand equations given in Section, lower b implies larger size of market S. Proposition below tells us that, when firm S does not export its products to market T in the equilibrium of the EP F subgame, larger size of market S makes optimal Southern IP R protection become more stringent. When firm S exports its products to market T, this result overturns. That is, larger size of market S induces the South to relax its optimal IP R protection. Proposition. β (b) is strictly increasing in b for all µ µ, and it is decreasing in b otherwise.

16 Ghosh, Morita, and Nguyen (2010) 15 In the equilibrium of the entire game, the social planner in the South chooses β = β. Let us consider the case µ µ so that β = β makes firm N indifferent between {e 1 } equilibrium and {f 1 } equilibrium (and it chooses EP F by simplifying assumption). What is the impact of a decrease in b on β (b)? Since firm N s profit obtained from market T becomes higher under EP F than under HP in this case (gain from T ), its profit obtained from market S is smaller (loss from S) which offsets the gain and makes firm N indifferent between HP and EP F. Smaller b dampens the loss in market S for firm N so that to induce firm N to undertake EP F, the level of spillover rate should be set smaller. This logic, however, does not apply for the case firm S exports under EP F. That is, if we consider the case of µ < µ, in which the South chooses β = β and firm N is indifferent between HP equilibrium and {f 2 } equilibrium and it undertakes EP F by simplifying assumption. In this case, firm N experiences a loss in market T rather than a gain when it undertakes EP F since the market T will be shared with firm S upon EP F. As a result, β = β (b) should be chosen such that firm N can make higher profit from market S with EP F than with HP. All else equal, smaller b in this case benefit firm N, and thus enable the South to decrease its IP R protection yet still induces EP F. This explain the logic behind Proposition. In summary, we have shown in this section that, the social planner in the South should choose a loose-enough IP R policy that still encourage EP F undertaken by firm N, and consequently the equilibrium of the game is an EP F equilibrium. When the South becomes larger (in term of market size), if the Southern firm does not export in the equilibrium of the game, then Southern IP R policy becomes more stringent. However, if the Southern firm exports, this result overturns. That is, larger market S makes Southern IP R policy become more lax. In the next section, we continue to examine the impacts of regional trade liberalization between the South and third market on optimal IP R policy. 6 Impacts of trade liberalization This section studies the welfare impacts of a decrease in µ, which represents trade liberalization between the South and third country (regional trade liberalization). In the traditional export platform literature, previous authors argued that this regional trade liberalization induces EP F by the outsider (Northern) firm (see more in Section 2). In our set up, the presence of technology upon Southern production makes this location choice of firm N become more strategic since a reduction in µ also benefits firm S, which could intensify competition in market T, a result which the previous authors had not examined. In what follows, to focus on the analysis concerning µ, we assume that the social planner in the South can freely choose the level of spillover rate to maximize Southern welfare. Thus, β = β holds throughout the analysis here forth. Then, we let β = β (µ) to explore the impacts of a change in µ on post-equilibrium market structure and Southern welfare.

17 Ghosh, Morita, and Nguyen (2010) 16 We start with the case firms N and S competing in market T in a Cournot fashion under the equilibrium of EP F subgame (i.e., {f2} equilibrium), which happens when β β and µ < µ hold. Then, since both firms N and S s equilibrium quantity levels in market T are decreasing in µ, a decrease in µ increases both firms profit taken from market T. What are the impacts on welfare of this reduction in µ? Since µ only affects the choice of quantity levels in market T while it does not change the nature of competition in market S, it follows that the reduction in µ improves Southern welfare by increasing firm S s profitability. In other words, regional trade liberalization benefits the South in this case. As we mentioned earlier, when µ decreases, firm N has more incentive to undertake EP F. Then, the social planner in the South could increase the level of spillover rate until β = β (µ) holds, which still induce EP F while maximizing the benefits of technology spillover. That is, as µ declines, β (µ) increases. When µ happens to be µ [µ, B], a decrease in µ does not affect Southern welfare given β = β = β holds. This is because firm S does not export to market T in this case so the reduction in µ only benefits firm N upon EP F. Again, as µ decreases, firm N has more incentive to undertake EP F, so that the social planner can increase the value of spillover rate until β = β (µ) holds. We can now summarize the above results in Proposition 4. Proposition 4. Southern IPR policy becomes more lax as the the third country lowers its tariff for South. That is, β (µ) is strictly decreasing in µ. As discussed earlier, by choosing β = β (µ), Southern welfare is maximized in the equilibrium of the game. Proposition 4 says that, regional trade liberalization between the South and third country induces the South to relax its protection for the foreign firm s technology. This result suggests that the recent progress in trade liberalization could be a possible reason why IP R is becoming an increasingly important issue in North - South trade contexts nowadays. Many Southern country governments have put much efforts in negotiating regional trade liberalization to boost export for both local firms and foreign firms upon production in the South. However, many foreign firms have claimed that, their advanced know-how has been imitated easily by Southern competitors. 15 Given this result, we can now wrap up our analysis by exploring the impacts of regional trade liberalization between the South and third country on post-equilibrium market structure and its implications on welfare. It follows from Lemma and Proposition 4 that, the more trade is liberalized, the more benefits the South could reap upon inducing firm N to undertake EP F by choosing β = β (µ). Furthermore, when µ < µ holds, post-equilibrium market structure is duopoly in market T, as formalized in Proposition For instance, in China s automobile industry, many foreign automakers have sued local competitors for copyright issue. Among those, in 2005, General Motors filed suit in Shanghai court alleging that local firm Chery Automobile stole its trade secrets from Spark car in the production of competing QQ mini cars; in 200, Toyota sued Chinese car maker Geely for copying the Japanese company s logo and slapping it on Geely models. Source: 06/b mz001.htm

18 Ghosh, Morita, and Nguyen (2010) 17 Proposition 5. Post-equilibrium market structure in third country is duopoly if µ [0, µ ), and it is monopoly if µ [µ, B]. Proposition 5 tells us that, to induce firm S to export to market T when firm N undertakes EP F, trade liberalization between the South and third country (regional trade liberalization) must be high enough (µ is relatively small). To understand the logic behinds this result, let us first consider the case when µ [µ, B] (Figure and 4). In this case, firm S does not export to market T regardless of firm N s location choice. A change in µ [µ, B], therefore, does not affect firm S s profitability. In contrast, if µ [0, µ ), firm S exports to market T upon EP F provided that β = β (µ), so that a change in µ affects its profitability. Specifically, a decrease in µ decreases firm S s cost serving market T, thus raises its profitability. This in turn improves Southern welfare in this case. The results under Proposition 5 captures many phenomena that happen in reality. Particularly, it provides an explanation for why several countries such as China and ASEAN members have recently attracted huge amount of foreign investments in export sectors. Trade liberalization between China and many Asian partners, or free trade agreement among the ASEAN members (AFTA) makes those countries attractive locations for foreign companies to shift their production from other countries to. With a relatively loose IP R regime being adopted in these countries, the presence of foreign firms tend to generate positive externalities to local competitors that eventually induce these local firms to enter the export market. Our analysis suggests that this policy mix (trade liberalization with export market and loose IP R regime) maximizes the benefits of the inclusion of foreign firms thanks to the impacts of technology spillover. In summary, this section explores the impacts of trade liberalization between the South and third country on optimal IP R policy for the South and market structure. It suggests that, the South should liberalize trade with the export market (third country) in order to maximize the benefits associated with EP F undertaken by the Northern firm. 7 Discussion and conclusions Why do Southern countries promote EP F? In this paper, we demonstrate that, EP F not only benefits Southern firm with technology spillover, it also improves Southern welfare. The benefit is amplified in case the Southern firm could make a positive profit in the export market of the Northern firm. Our analysis strengthens the findings under technology spillover literature which argued that F DI usually improves Southern welfare (Naghavi, 2007 and Morita and Nguyen, 2010). Adopting a traditional EP F framework, we also show that, trade liberalization between the South and third country could transform market structure from monopoly to duopoly in the third country market. The inclusion of technology spillover (weak IP R regime) makes the location choice of the Northern firm between home-production and EP F in the South become strategic since EP F