Introduction Model Equilibrium characterization Effects of trade policy Effects of spillover Conclusion

FDI, Technology Spillover, and Vertical ProductDifferentiation

Hodaka Morita and Nguyen Thanh Xuan

University of New South Wales

Presentation at ESAM09 - ANU, Jul 2009

Introduction Model Equilibrium characterization Effects of trade policy Effects of spillover Conclusion

Introduction

FDI induces technology spillover, which often enhances localfirm’s quality standards.

Northern firms with superior technology often introducesecond-best or outdated technology in FDI affiliates.

Example: The Japanese flying geese model; Hongkong’s FDIin China’s garment industry.

Example: Chery Automobile hired a number of engineers fromNissan-Dongfeng joint venture which was established uponNissan’s FDI in China. Technology spillover through theseengineers significantly enhanced Chery’s product quality.

Introduction Model Equilibrium characterization Effects of trade policy Effects of spillover Conclusion

Introduction

FDI induces technology spillover, which often enhances localfirm’s quality standards.

Northern firms with superior technology often introducesecond-best or outdated technology in FDI affiliates.

Example: The Japanese flying geese model; Hongkong’s FDIin China’s garment industry.

Example: Chery Automobile hired a number of engineers fromNissan-Dongfeng joint venture which was established uponNissan’s FDI in China. Technology spillover through theseengineers significantly enhanced Chery’s product quality.

Introduction Model Equilibrium characterization Effects of trade policy Effects of spillover Conclusion

Introduction

FDI induces technology spillover, which often enhances localfirm’s quality standards.

Northern firms with superior technology often introducesecond-best or outdated technology in FDI affiliates.

Example: The Japanese flying geese model; Hongkong’s FDIin China’s garment industry.

Example: Chery Automobile hired a number of engineers fromNissan-Dongfeng joint venture which was established uponNissan’s FDI in China. Technology spillover through theseengineers significantly enhanced Chery’s product quality.

Introduction Model Equilibrium characterization Effects of trade policy Effects of spillover Conclusion

Research questions

Under what conditions does a Northern firm undertake FDI ina Southern country in the presence of quality-enhancingtechnology spillover?

How does spillover affect the Northern firm’s choice ofproduct quality?

Welfare consequences of trade policy and technology spillover(IPR) in this context.

Introduction Model Equilibrium characterization Effects of trade policy Effects of spillover Conclusion

Research questions

Under what conditions does a Northern firm undertake FDI ina Southern country in the presence of quality-enhancingtechnology spillover?

How does spillover affect the Northern firm’s choice ofproduct quality?

Welfare consequences of trade policy and technology spillover(IPR) in this context.

Introduction Model Equilibrium characterization Effects of trade policy Effects of spillover Conclusion

Research questions

Under what conditions does a Northern firm undertake FDI ina Southern country in the presence of quality-enhancingtechnology spillover?

How does spillover affect the Northern firm’s choice ofproduct quality?

Welfare consequences of trade policy and technology spillover(IPR) in this context.

Introduction Model Equilibrium characterization Effects of trade policy Effects of spillover Conclusion

Relationship to the literature

Cost-reducing technology spillover:

Chin and Grossman (1990)

Cournot duopoly in an integrated world economy.

Firm N and firm S . Homogeneous good. Constant MC.

Firm N: cost-reducing R&D ⇒ may spillover to firm S .

North-South conflict with low R&D efficiency while consensuswith high R&D efficiency.

Zigic (1998, 2000), Naghavi (2007), Glass and Saggi (2002).

Introduction Model Equilibrium characterization Effects of trade policy Effects of spillover Conclusion

International duopoly of vertical product differentiation

Firm N and firm S compete in the South.

Firm S is in the South, while firm N chooses HP or FDI .

Let qk (k = N, S) denote the quality of firm k ’s product.

Demand side

Two group of consumers: Group j with mass mj , j = H, L.

Each group j consumer consumes 0 or 1 unit of the products.Gross benefit: vjqk , where vH > vL > 0. A simplification ofMussa and Rosen (1978).

Introduction Model Equilibrium characterization Effects of trade policy Effects of spillover Conclusion

Quality choice and technology spillover

No fixed costs and constant MC, ck(qk), k = N, S .

qN can take any positive value while qS ≤ q̂S must hold.

HP subgame

q̂S = q̄S .

cN(qN) = c(qN) + w and cS(qS) = c(qS).

A specific tariff, t.

FDI subgame

q̂S = max(q̄S + θ(qN − q̄S), q̄S), θ ∈ [0, 1).

Interpretation of θ.

cN(qN) = c(qN) and cS(qS) = c(qS).

Let c(qk) = 12q2

k .

Introduction Model Equilibrium characterization Effects of trade policy Effects of spillover Conclusion

Timing of the game

[Stage 1] Firm N chooses HP or FDI .

[Stage 2] Firm N chooses qN . Having observed qN , firm Schooses qS , subject to qS ≤ q̂S .

[Stage 3] Firm N and firm S simultaneously set prices for theirown products, and then consumers make purchase decisions.

Introduction Model Equilibrium characterization Effects of trade policy Effects of spillover Conclusion

Proposition 1

Derive SPNE. Focus on Segmentation Equilibria, where firm Nsells its product to all type-H consumers only while firm S sells itsproduct to all type-L consumers only.

Proposition 1:

There exist a unique value m̃H > 0 such that the game has asegmentation equilibrium if and only if mH > m̃H .

If mH > m̃H , the segmentation equilibrium is the uniqueequilibrium of the game.

Introduction Model Equilibrium characterization Effects of trade policy Effects of spillover Conclusion

Proposition 1 (cont.)

In the segmentation equilibrium,pS = vLqS and pN = vHqN − (vH − vL)qS .

Firm S extracts all surplus from type L consumers by chargingpS = vLqS .

Firm N must give the rent (vH − vL)qS to type H consumers.

In the FDI equilibrium, profits of firms N and S arerespectively πN(qN) = mH [vHqN − (vH − vL)qS − 1

2q2N ] and

πS(qS) = mL[vLqS − 12q2

S ].

At stage 2, firm S chooses qS = min{vL, q̂S}.Therefore, if q̂S < vL, an increase in θ increases firm S ’sequilibrium quality, decreases firm N’s profit.

Introduction Model Equilibrium characterization Effects of trade policy Effects of spillover Conclusion

Proposition 1 (cont.)

In the segmentation equilibrium,pS = vLqS and pN = vHqN − (vH − vL)qS .

Firm S extracts all surplus from type L consumers by chargingpS = vLqS .

Firm N must give the rent (vH − vL)qS to type H consumers.

In the FDI equilibrium, profits of firms N and S arerespectively πN(qN) = mH [vHqN − (vH − vL)qS − 1

2q2N ] and

πS(qS) = mL[vLqS − 12q2

S ].

At stage 2, firm S chooses qS = min{vL, q̂S}.Therefore, if q̂S < vL, an increase in θ increases firm S ’sequilibrium quality, decreases firm N’s profit.

Introduction Model Equilibrium characterization Effects of trade policy Effects of spillover Conclusion

Proposition 1 (cont.)

In the segmentation equilibrium,pS = vLqS and pN = vHqN − (vH − vL)qS .

Firm S extracts all surplus from type L consumers by chargingpS = vLqS .

Firm N must give the rent (vH − vL)qS to type H consumers.

In the FDI equilibrium, profits of firms N and S arerespectively πN(qN) = mH [vHqN − (vH − vL)qS − 1

2q2N ] and

πS(qS) = mL[vLqS − 12q2

S ].

At stage 2, firm S chooses qS = min{vL, q̂S}.Therefore, if q̂S < vL, an increase in θ increases firm S ’sequilibrium quality, decreases firm N’s profit.

Introduction Model Equilibrium characterization Effects of trade policy Effects of spillover Conclusion

Proposition 2

Proposition 2:

Suppose mH > m̃H . There exists a value θ∗ ∈ (0, 1] such thatthe equilibrium of the game is an FDI equilibrium if θ < θ∗,and it is an HP equilibrium if θ ≥ θ∗.There exists a value Ψ ≥ 0 such that θ∗(< 1) is strictlyincreasing in t if q̄S < vL and t + w ≤ Ψ, and θ∗ = 1otherwise.

Introduction Model Equilibrium characterization Effects of trade policy Effects of spillover Conclusion

Effects of trade policy

Comparative statics exercises in terms of t.

Assume mH > m̃H for all t ≥ 0 ⇔ The game has asegmentation equilibrium for all t ≥ 0.

Notations: πN(t), πS(t), CS(t), TS(t), and WW (t).

Analyze the case of q̄S < vL, w ≤ Ψ, and θ ≥ θ∗|t=0.Otherwise, firm N chooses FDI for all t ≥ 0.

Lemma 1. Suppose q̄S < vL, w ≤ Ψ, and θ ≥ θ∗|t=0, there existsa threshold t̄ such that:(i) The equilibrium of the game is an HP equilibrium if t ≤ t̄, and(ii) The equilibrium of the game is an FDI equilibrium if t > t̄.

Introduction Model Equilibrium characterization Effects of trade policy Effects of spillover Conclusion

Proposition 3

Proposition 3. For all t ∈ [0, t̄],

t ↑ ⇒ πN(t) ↓, TS(t) ↑.t ↑ ⇒ no effects on πS(t), CS(t), WW (t).

For t ∈ [0, t̄], tariff functions as a channel for welfare transferbetween firm N and Southern government.

Introduction Model Equilibrium characterization Effects of trade policy Effects of spillover Conclusion

Proposition 4

Compare t = t̄ (HP) and t = t ′ > t̄ (FDI ).

Proposition 4. CS(t ′) > CS(t̄) and πS(t ′) > πS(t̄) hold.

Firm S ’s profit: πS(qS) = mL[vLqS − 12q2

S ].

Consumer surplus: CS = mH(vH − vL)qS .

HP ⇒ No spillover ⇒ qS = q̄.

FDI ⇒ Spillover ⇒ qS > q̄.

Introduction Model Equilibrium characterization Effects of trade policy Effects of spillover Conclusion

Proposition 5

πN(t ′) = πN(t̄) and WW (t) = TS(t) + πN(t)⇒ TS(t ′) > TS(t̄) ⇔ WW (t ′) > WW (t̄)

Proposition 5. There exists values v̂L > q̄S and m̄H ≥ m̃H withthe following properties:

(i) If vL ≤ v̂L, TS(t ′) > TS(t̄) and WW (t ′) > WW (t̄).(ii) If vL > v̂L,

TS(t ′) > TS(t̄) and WW (t ′) > WW (t̄) if mH < m̄H .

TS(t ′) < TS(t̄) and WW (t ′) < WW (t̄) if mH > m̄H .

Introduction Model Equilibrium characterization Effects of trade policy Effects of spillover Conclusion

Logic behind Proposition 5

Efficient (WW maximizing) quality levels:qWWN = vH , qWW

S = vL.

Recall πN(qN) = mH [vHqN − (vH − vL)qS − 12q2

N ].

qN = vH ⇒ q̂S = q̄S + θ(vH − q̄S).

By choosing qN = q′N < vH instead of qN = vH , firm N canreduce qS from min(q̄S + θ(vH − q̄S), vL) to q̄S + θ(q′N − q̄S).

Firm N’s benefit of choosing suboptimally low level of qN

decreases as vL decreases.

There exists v̂L (< min(q̄S + θ(vH − q̄S), vL)) such thatq∗N = vH if vL ≤ v̂L andq∗N = (1− θ)vH + θvL (< vH) if vL > v̂L.

This implies Proposition 5.

Introduction Model Equilibrium characterization Effects of trade policy Effects of spillover Conclusion

Effects of trade policy: Figures

Figure 1a. vL ∈ (q̄S , v̂L]; or vL > v̂L and mH < m̄H .

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WW

TS

πN

G

CS

πS

t̄ t

welfare

0� HP- � FDI -

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Introduction Model Equilibrium characterization Effects of trade policy Effects of spillover Conclusion

Effects of trade policy: Figures (cont.)

Figure 1b. vL > v̂L, mH > m̄H .

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TSπN

G

CS

πS

t̄ t

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Introduction Model Equilibrium characterization Effects of trade policy Effects of spillover Conclusion

Effects of trade policy: Summary

In the presence of technology spillover, trade policy of theSouth may affect not only location choice but also qualitychoice of the Northern firm.

An increase in tariff may induce the Northern firm toundertake FDI , which benefits the Southern firm as well asSouthern consumers.

Induced FDI can increase or decrease the Southern welfareand the world welfare.

Introduction Model Equilibrium characterization Effects of trade policy Effects of spillover Conclusion

Effects of trade policy: Summary

In the presence of technology spillover, trade policy of theSouth may affect not only location choice but also qualitychoice of the Northern firm.

An increase in tariff may induce the Northern firm toundertake FDI , which benefits the Southern firm as well asSouthern consumers.

Induced FDI can increase or decrease the Southern welfareand the world welfare.

Introduction Model Equilibrium characterization Effects of trade policy Effects of spillover Conclusion

Effects of trade policy: Summary

In the presence of technology spillover, trade policy of theSouth may affect not only location choice but also qualitychoice of the Northern firm.

An increase in tariff may induce the Northern firm toundertake FDI , which benefits the Southern firm as well asSouthern consumers.

Induced FDI can increase or decrease the Southern welfareand the world welfare.

Introduction Model Equilibrium characterization Effects of trade policy Effects of spillover Conclusion

Effects of technology spillover

Comparative statics exercises in terms of θ.

Assume mH > m̃H for all θ ∈ [0, 1) ⇔ The game has asegmentation equilibrium for all θ ∈ [0, 1).

Focus on the case of vL > q̄S , because, if vL ≤ q̄S , technologyspillover has no role to play.

Notations: πN(θ), πS(θ), CS(θ), TS(θ), and WW (θ).

Lemma 2. Suppose that the equilibrium of the game is an FDIequilibrium. Then, there exists a threshold θ̂ ∈ (0, 1) such thatq∗N = (1− θ)vH + θvL < vH if θ < θ̂ and q∗N = vH if θ ≥ θ̂.

Introduction Model Equilibrium characterization Effects of trade policy Effects of spillover Conclusion

Proposition 7

Proposition 7. There exist parameterizations underwhich0 < θTS < 1, where θTS is the optimal level of technology spilloverfor the South.

See figure 2b.

Introduction Model Equilibrium characterization Effects of trade policy Effects of spillover Conclusion

Proposition 7 (cont.)

Figure 2b

WW

TS

π∗N

CS

π∗S

θ∗θ̃ 1θ

welfare

0� FDI -� HP-

(qN < vH)

?

?

?

?

Introduction Model Equilibrium characterization Effects of trade policy Effects of spillover Conclusion

Proposition 9

Proposition 9. θWW ≤ θTS holds, where θWW maximizes worldwelfare.

Northern firm strictly prefers θ = 0

Southern firm optimally chooses θ > 0

The world planner chooses 0 < θWW < θTS .

See figure 2e.

Introduction Model Equilibrium characterization Effects of trade policy Effects of spillover Conclusion

Proposition 9 (cont.)

Figure 2e

WW

TS

π∗N

CS

π∗S

θ̃ θ̂ θ∗ = 1

welfare

0� FDI -� FDI-

(qN < vH) (qN = vH)

6

6

6

6

Introduction Model Equilibrium characterization Effects of trade policy Effects of spillover Conclusion

Effects of Technology spillover: Summary

Spillover rate may affect not only location choice but alsoquality choice of the Northern firm.

An increase in spillover rate may induce Northern firm toswitch from FDI to HP.

Northern firm strictly prefers a zero spillover rate, while thespillover rate that maximizes world welfare is (weakly) lessthan that maximizes Southern welfare.

Introduction Model Equilibrium characterization Effects of trade policy Effects of spillover Conclusion

Effects of Technology spillover: Summary

Spillover rate may affect not only location choice but alsoquality choice of the Northern firm.

An increase in spillover rate may induce Northern firm toswitch from FDI to HP.

Northern firm strictly prefers a zero spillover rate, while thespillover rate that maximizes world welfare is (weakly) lessthan that maximizes Southern welfare.

Introduction Model Equilibrium characterization Effects of trade policy Effects of spillover Conclusion

Effects of Technology spillover: Summary

Spillover rate may affect not only location choice but alsoquality choice of the Northern firm.

An increase in spillover rate may induce Northern firm toswitch from FDI to HP.

Northern firm strictly prefers a zero spillover rate, while thespillover rate that maximizes world welfare is (weakly) lessthan that maximizes Southern welfare.

Introduction Model Equilibrium characterization Effects of trade policy Effects of spillover Conclusion

Conclusion

Trade protection in the South harms Northern firm but makesboth Southern firm and consumers better-off. The impact onworld welfare and Southern welfare is, however, ambiguous.

In FDI subgame, Northern firm may lower its product qualityfrom the socially efficient level.

The North strictly prefers a zero spillover rate, while theSouth may not necessarily choose spillover rate equal to 1.

The spillover rate that maximizes world welfare is (weakly)less than that maximizes Southern welfare.

Our model, therefore, yields more insights and is morerelevant with reality than the homogeneous product approach.

Introduction Model Equilibrium characterization Effects of trade policy Effects of spillover Conclusion

Conclusion

Trade protection in the South harms Northern firm but makesboth Southern firm and consumers better-off. The impact onworld welfare and Southern welfare is, however, ambiguous.

In FDI subgame, Northern firm may lower its product qualityfrom the socially efficient level.

The North strictly prefers a zero spillover rate, while theSouth may not necessarily choose spillover rate equal to 1.

The spillover rate that maximizes world welfare is (weakly)less than that maximizes Southern welfare.

Our model, therefore, yields more insights and is morerelevant with reality than the homogeneous product approach.

Introduction Model Equilibrium characterization Effects of trade policy Effects of spillover Conclusion

Conclusion

Trade protection in the South harms Northern firm but makesboth Southern firm and consumers better-off. The impact onworld welfare and Southern welfare is, however, ambiguous.

In FDI subgame, Northern firm may lower its product qualityfrom the socially efficient level.

The North strictly prefers a zero spillover rate, while theSouth may not necessarily choose spillover rate equal to 1.

The spillover rate that maximizes world welfare is (weakly)less than that maximizes Southern welfare.

Our model, therefore, yields more insights and is morerelevant with reality than the homogeneous product approach.

Introduction Model Equilibrium characterization Effects of trade policy Effects of spillover Conclusion

Conclusion

Trade protection in the South harms Northern firm but makesboth Southern firm and consumers better-off. The impact onworld welfare and Southern welfare is, however, ambiguous.

In FDI subgame, Northern firm may lower its product qualityfrom the socially efficient level.

The North strictly prefers a zero spillover rate, while theSouth may not necessarily choose spillover rate equal to 1.

The spillover rate that maximizes world welfare is (weakly)less than that maximizes Southern welfare.

Our model, therefore, yields more insights and is morerelevant with reality than the homogeneous product approach.

Introduction Model Equilibrium characterization Effects of trade policy Effects of spillover Conclusion

Conclusion

Trade protection in the South harms Northern firm but makesboth Southern firm and consumers better-off. The impact onworld welfare and Southern welfare is, however, ambiguous.

In FDI subgame, Northern firm may lower its product qualityfrom the socially efficient level.

The North strictly prefers a zero spillover rate, while theSouth may not necessarily choose spillover rate equal to 1.

The spillover rate that maximizes world welfare is (weakly)less than that maximizes Southern welfare.

Our model, therefore, yields more insights and is morerelevant with reality than the homogeneous product approach.