Journal of Development Economics 90 (2009) 231–236

Contents lists available at ScienceDirect

Journal of Development Economics

j ourna l homepage: www.e lsev ie r.com/ locate /econbase

Intellectual property rights, technology transfer and exports indeveloping countries☆

Lei Yang a, Keith E. Maskus b,⁎a School of Accounting and Finance, The Hong Kong Polytechnic University, Hong Kongb Department of Economics, UCB 256, University of Colorado, Boulder CO 80309, USA

☆ We thank Yongmin Chen, Gordon Hanson, James Mreferees for their helpful comments and suggestions.⁎ Corresponding author. Tel.: +1 303 492 7588.

E-mail addresses: aflyang@inet.polyu.edu.hk (L. Yang(K.E. Maskus).

0304-3878/$ – see front matter © 2008 Elsevier B.V. Adoi:10.1016/j.jdeveco.2008.11.003

a b s t r a c t

a r t i c l e i n f o

Article history:

We develop a model to an Received 22 November 2006Received in revised form 30 July 2008Accepted 3 November 2008

JEL Classification:F14L13O1O34

Keywords:Intellectual property rightsTechnology transferExports

alyze one mechanism under which stronger intellectual property rights (IPR)protection may improve the ability of firms in developing countries to break into export markets. A Northernfirmwith a superior process technology chooses either exports or technology transfer through licensing as itsmode of supplying the Southern market, based on local IPR policy. Given this decision, the North and Southfirms engage in Cournot competition in both markets. We find that stronger IPR would enhance technologytransfer through licensing and reduce the South firm's marginal production cost, thereby increasing itsexports. Welfare in the South would rise (fall) if that country has high (low) absorptive capacity. Excessivelystrong IPR diminish competition and welfare, however. Adding foreign direct investment as an additionalchannel of technology transfer sustains these basic messages.

© 2008 Elsevier B.V. All rights reserved.

1. Introduction

Since 1995 many developing countries have reformed their lawsgoverning intellectual property rights (IPR). Reforms in IPR arecommonly presumed by trade economists to raise imitation costs,reduce access to global information and place firms in developingcountries at a competitive disadvantage in global markets (Helpman,1993; Lai and Qiu, 2004). However, one essential purpose of IPR is toreduce the costs of technology transfer (Maskus, 2004). Indeed,empirical evidence supports the view that multinational firms expandtechnology flows through greater foreign direct investment (FDI) andlicensing as local patent rights are improved (Smith, 2001; Branstetteret al., 2005).

By expanding access to international technologies, strengthened IPRcould improve the export performance of recipient firms, a possibilitythat has been little studied to date. In this paper we provide a model ofcontracting and technology transfer that illuminates one such mechan-ism. Specifically, we analyze a model of two-country competition

arkusen, Walter Park and two

), keith.maskus@colorado.edu

ll rights reserved.

between a Northern firm and an unaffiliated Southern firm, where theformer may choose to provide cost-reducing technical information tothe latter through licensing or FDI. We find conditions under whichgreater transfers are made in equilibrium under stronger patents andthe consequent effect on exports of the Southern firm. Welfare in theSouthern country increases if its firm has high absorptive ability, butcould fall if it has a weak capacity to implement new technology.

In contrast to our strategic approach, the theoretical literaturegenerally has set out general-equilibrium, North–South product-cyclemodels among atomistic firms competing dynamically. Helpman(1993) and Glass and Saggi (1999) assumed stronger IPR would raiseimitation costs, tending to diminish technology flows and globalinnovation. Lai (1998) noted that innovation could be enhanced if FDIis the form of technology transfer. Yang andMaskus (2001) found thatpatent reforms would both raise imitation costs and reduce the costsof technology licensing, with the latter encouraging greater informa-tion transfer and innovation in equilibrium.

These insights are valuable. However, to make these dynamicmodels tractable the authors forego analysis of strategic interactionsamong firms. The primary advantage of our approach is to permitdetailed analysis of the microeconomic tradeoffs involved in con-tracting in response to IPR changes. Our bargaining frameworkexplicitly considers strategic choices among imitation, licensing, andFDI at various ranges of patent strength, generating a rich menu of

232 L. Yang, K.E. Maskus / Journal of Development Economics 90 (2009) 231–236

tradeoffs and welfare calculations that cannot readily be analyzed inthe more general context. Of course, the partial-equilibrium Cournotcontext within which we operate also makes strong assumptions fortractability.1 Thus, we comment later on how the results would varywith alternative assumptions.

Empirical evidence in several developing countries suggests thatinvesting in technology is important for entering export markets(Hasan and Raturi, 2001). Key sources of such investment are importsof technology and linkages to multinational firms (Kumar andSiddharthan, 1993). However, this literature has paid little attentionto the combination of IPR, technology transfer and trade in order toestablish a linkage between IPR and exports. A recent exception isBranstetter et al. (2007), whose empirical analysis found an increasein export intensity of local affiliates of multinational firms after IPRpolicy changes. Again, none of these papers considered the detailedmechanisms under which IPR reforms could expand technologytransfer and exports.

As empirical motivation for our framework, within which patentreforms may encourage more technology transfer through unaffiliatedlicensing, with a subsequent boost to exports, consider two recenthistories from East Asia. South Korea engineered a major strengtheningof its patent laws from 1988 to 1995 (La Croix and Kawaura, 1996),increasing itsmeasured patent index by 47%, from 2.65 to 3.89, between1985 and 1995.2 Taiwan (Chinese Taipei) made substantial reforms in1986 and 1994 (Diallo, 2003), raising its index by 152%, from1.26 to 3.17,over the same period. South Korea's licensing payments to unaffiliatedU.S.firms rose from$38million in 1987 to $717million in 1995, reaching$1.686 billion in 2005. Taiwan's licensing payments to unaffiliated U.S.firms rose from $17 million in 1986 to $267 million in 1996, reaching$1.165 billion in 2006. Finally, South Korea's merchandise exports rosefrom$28.5 billion in1985 to $99.5 billion in 1995, reaching$284.4 billionin 2005. Taiwan's exports similarly rose from $33.4 billion in 1985 to$128.4 billion in 1995, reaching $223.7 billion in 2006.3

2. The model

We study the effects of IPR on export development in anoligopolisticsetting. Consider a world economy of two regions, North and South.Assume that atmost onefirm in each country canprofitably produce thegood. We denote these firms by N and S. Both firms produce a singlehomogenous good and compete in Cournot fashion. Assume also thatthe two markets are segmented, in the sense that firms can charge adifferent price in each market.

2.1. Consumption

Let the utility functions in both regions be quadratic in the good westudy, with an additive term for a second composite good. If A and Brepresent the market size of North and South, respectively, the inverse-demand functions for our good are

pN = A − qN; pS = B − qS: ð1Þ

We assume that market sizes are sufficiently greater than marginalcosts to ensure positive production.

2.2. Decision on mode of supply

Only the N firm engages in prior R&D, which achieves proprietarytechnological knowledge embedded in the production process for its

1 Vishwashrao (1994) is an early example of a strategic model of IPR and technologytransfer.

2 This measure is the well known Ginarte–Park index, explained in Ginarte and Park(1997).

3 Sources for these data include the on-line WTO statistics database, World BankWorld Development Indicators (CD-ROM), and U.S. Department of Commerce (2007).

good. It can retain production at home and export the good to market S,risking loss of its knowledge through imitation, or transfer thetechnology through licensing.4 The choice depends on the absorptivecapacityof the licensee,market size, the threatof imitation, and the legalprotection of technology.

We assume that codified knowledge (e.g., blueprints and formulas)canbe imitatedbyS, but tacit knowledge (e.g., know-howand informationgained from experience) cannot. Imitation of codified knowledge is costlyand can be achieved under the export mode through product inspection,reverse engineering, or trial and error. Imitation permits S to avoid payinglicense feesbut the reduction in itsproductioncosts is less than itwouldbewith licensing because the firm cannot acquire know-how this way.

N may instead offer to license production rights to S. In this eventthe licensing contract specifies a lump-sum fee and S is able toproduce the good at reduced marginal cost with partial access toknow-how. If S accepts the licensing contract it would have noincentive to imitate. Thus, its problem is a tradeoff between the licensefee and imitation costs, with different impacts onmarginal productioncosts.

Our specification of a lump-sum license fee without per-unitroyalties captures the empirical reality that a large portion oftechnology contracts in developing countries have this feature. Forexample, Vishwasrao (2007) assembled data on all foreign technologylicensing agreements entered into by manufacturing firms, unaffi-liated with the licensors, in India between 1989 and 1993. Over theperiod 1991–1993, therewere 968 contracts with only lump-sum fees,amounting to 45% of all licensing deals.

2.3. Costs and production

We assume that labor is the only factor of production and that N'smarginal production cost is cN. Before any imitation or licensing, let S'smarginal production cost be cS, which is greater than cN because the firmhas no knowledge of N's improved technology. A key parameter, theabsorptive ability of S, is denoted by a∈ [0, 1], where an increase in aindicates higher learning capacity. This capacity is exogenous and givenby such characteristics of the South market as education level andinfrastructure. Because a stronger learning capacity would permit moreefficient production, we assume that imitation reducesmarginal cost bymore, the greater is a. The reduced cost is cS−m(a),m′N0.

Let k∈ [0, 1] be the strength of IPR in the South. Parameter k is 1when patent protection is highest and 0 if patents are absent. Denoteby I(k, a) the S firm's imitation cost. Stronger IPR make it harder for Sto imitate N's product. Indeed, as IPR protection approaches itsmaximum the costs of legally imitating around a patent become quitehigh. Thus, we suppose that imitation will not occur beyond someless-than-full level of protection.5 At the same time, a higherabsorptive capacity makes it easier for S to imitate.

There are costs of transferring technology through licensing. Twocomponents of these costs involve setting enforceable contract termsand shifting codified knowledge. These costs typically fall as SouthernIPR are tightened because enforceable patents and trade secrets reducecontracting problems under asymmetric information and limit the needfor N to masque its proprietary knowledge (Taylor, 1994; Yang andMaskus, 2001). The third component of transfer cost is ensuring thatlocal partners gain the know-how needed to produce efficiently. Weassume that these costs increase with the proportion of know-howtransferred, whichwe capture by parameter x∈ [0,1]. Thus, let licensingincur a transfer cost F(x, k)=φ+G(x, k), whereφ is a fixed transfer costand variable costGdecreaseswith the strengthof IPR and increaseswiththeproportion of know-how transferred.6 This transfer cost F is borneby

4 We extend the model to technology transfer through FDI in the next section.5 One proof below relies on a convexity assumption that @2 I

@k2 b0, though this cost canget high enough to deter imitation.

6 We assume that @2G x;kð Þ@x@k b0.

233L. Yang, K.E. Maskus / Journal of Development Economics 90 (2009) 231–236

both partners and enters only their payoff functions through a reductionin joint surplus. It does not directly affect production profits.

If S accepts the licensing contract, the technology is transferred andits marginal production cost becomes cS−r(x, a). Here r(x, a) is theadvantage to S of accepting the license and learningknow-how.Wepositthat this cost reduction is positively related to both S's absorptive abilityand the proportion of know-how thatN transfers, and is concave in bothx and a. Finally, assume that cSNcNNcS−m(a)≥cS−r(x, a). Thus, eitherimitation or licensing reduces S'smarginal cost belowN'sbut thedeclineis greater in the latter case.7

Nash bargaining determines the lump-sum license fee L, whichmustbe paid to gain production rights and know-how. Let τ be the bargainingpower of N and 1−τ that of S. This parameter determines the shares ofjoint surplus from sales under licensing. S's bargaining power reflects itslower labor cost and knowledge of local market conditions and N'spower reflects the uniqueness of its technology.

2.4. Decision structure under varying North import policies

In this game there are two players, firms S and N. Initially, N is theglobal (two-country) monopoly and S may imitate the technologythrough reverse engineering. Northern import policy related to IPR isimportant. The North may choose to permit imports from the S firm,even if that firm imitates the N technology without a license. However,such imitation could violate the patent issued in the North and N coulddirect its government to bar imitative imports.8We initially consider thecase without import blockage and then analyze competition subject tothis constraint.

The timing of the game without blockage is as follows. In the firststage, given the Southern IPR policy, N chooses either to export to theSouth, risking imitation,oroffera license. IfNexports, in thesecondstageS can choose to imitate, incurring a cost, or do nothing. If S imitatescompetition emerges in the third stage and the firms simultaneouslychoose quantities in both markets. If S does not imitate, N remains theglobal monopoly.

If N offers a license to S, the firms bargain over the fee. If thenegotiation succeeds, technology is transferred and both firmssimultaneously choose optimal quantities produced. Otherwise, Scan choose to imitate or not enter the market.

2.5. Equilibrium analysis

We begin by analyzing the equilibrium where N exports. Initiallysuppose that S chooses to imitate. Then the respective final-stagemaximization problems under export are

MaxΠNE = A − qENN − qESN� �

qENN + B − qENS − qESS� �

qENS − cN qENN + qENS� �

ð2Þ

MaxΠSE = A − qENN − qESN� �

qESN + B − qENS − qESS� �

qESS − cSE qESN + qESS� �

− I k; að Þ: ð3Þ

Here the E superscript refers to the exports equilibrium and cSE=cS−m(a). Solving for the optimal quantities, equilibrium profits underexporting are given by

ΠNET =A2 − 4AcN + 2AcSE + 8c2N − 8cNcSE + 2c2SE + B2 − 4BcN + 2BcSE

9ð4Þ

ΠSET =A2 + 2AcN − 4AcSE + 2c2N − 8cNcSE + 8c2SE + B2 − 4BcSE + 2BcN

9− I k; að Þ:

ð5ÞIf S chooses not to imitate and produce, its profit is 0. Let superscriptNB refer to no Northern import blockage and define k=k

_NB as the IPR

7 That is, we assume that m(a)= r(0,a), so that imitation is identical to the absenceof know-how transfer.

8 Such is the policy in the United States under Section 337of the 1930 Tariff Act, asamended.

level at which imitation cost just offsets production profit andΠSE⁎=0.9 S will imitate when kbk

_NB, with profit declining in k, and

will not enter when kNk_NB.

Next, if N offers a license and the negotiation fails, the equilibriumis the same as that under export. If licensing is offered and thenegotiation succeeds, N could have two choices in principle aftertransferring its process technology. It could continue producing andcompete with S in both markets. Alternatively, it could commit not toproduce, leaving S as a monopolist. However, in our game structurethis situation cannot survive as the equilibrium.10 The reason is thatthe license fee is a one-time transaction paid prior to the productionstage, so that a commitment not to compete is not credible. Wetherefore analyze the case where a license payment is made but bothfirms produce.

Maximizing the relevant profit functions in this case shows thatthe N firm's equilibrium production profits increase with thereduction in S marginal costs, sustaining the incentive to licensetechnology.11 In the negotiation stage, N decides how much know-howwill be transferred to S under the contract. The N profit equals thesum of the license fee and production profit under successfullicensing. Its maximization problem is12

Maxx

ΠNL = ΠNET + τ S1 x; að Þ + I k; að Þ− F x; kð Þ½ � ð6Þ

where S1N0 is an expression involving market sizes, marginal costs,and reductions in costs from imitation and licensing. The first term isN's profit under exports and the second term represents its share ofjoint surplus (in brackets), which Nmaximizes through its choice of x.Because S1 is positive, this joint surplus rises in k. We denote the first-order condition of Eq. (6) as f(x⁎, k, a). The equilibrium know-howtransferred satisfies

f xT; k; að Þ = 29A +

29B +

169

cN − 209

cS − r xT; að Þð Þ� �

@r xT; að Þ@x

− @F xT; kð Þ@x

= 0:

ð7ÞConsider briefly the situation in which the Northern government

blocks imitative imports but freely permits imports of goods producedby S under license. By restricting one competitive outlet (qSNE =0), theS firm's tradeoffs are altered. Performing the relevant substitutionsand computing profit functions, we find a threshold IPR level k

_B above

which S does not imitate and N remains a monopoly in both marketswith blocking. Below that level, N monopolizes its ownmarket but thefirms compete in South.

In the bargaining game under licensing, N's profit expression is thesum of its exports under blocking-aided monopoly (its reservationvalue) and its share of the joint surplus, where S can now export toNorth. We can show that the licensing equilibrium becomes morelikely the greater the reduction in S's marginal cost. Further, the largeris North market size, the less likely is licensing (import blockagesustains the monopoly in a large market) but the larger is the Southmarket the more likely is licensing. Thus, under some circumstances,duopoly profit under licensing can dominate monopoly profit underexport with imitation risk, even where the North government blocksimitative imports.

3. The impacts of IPR reform

In this section we study the effect of a stronger patent regime onthe extent of know-how licensed, exports, and the choice betweenexport and licensing.

9 By assumption this level is below full IPR protection. Later we analyze a functionalform where this assumption holds.10 We demonstrate this fact in a mathematical appendix available on request.11 From this point forward, profit functions are suppressed to save space.12 Determination of the license fee is in the mathematical appendix.

Fig. 1. Northern profits from export and licensing under north free imports and blockedimports.

14 The N profit level is constant under the imitation threat (low k) because a change

234 L. Yang, K.E. Maskus / Journal of Development Economics 90 (2009) 231–236

3.1. Extent of know-how transferred

Suppose that licensing is chosen. Differentiating expression (7)shows that

dxTdk

N 0 if A + B + 8cN − 10cSL N ϕ xT; að Þ; where ϕ xT; að Þ =10 @r xT;að Þ

@x

h i2− @2r xT;að Þ

@x2

: ð8Þ

This result demonstrates that stronger patent rights increase theamount of know-how transferred under large joint market size, highmarginal cost in N, and low marginal cost in S post-transfer. We cansimilarly show that the amount of know-how transferred increaseswith the absorptive ability of the S firm under the same conditions.These results hold under any licensing equilibrium, regardless ofNorth's import-blockage policy.

3.2. Southern exports

Suppose first that exports with imitation pertain at low k range.Our assumption that a rise in k affects S imitation cost but notmarginal cost implies that imitative exports are insensitive to policychanges in this region. Consider next the role of IPR on exports undersuccessful licensing.We saw that know-how transferred rises with IPRunder large joint market size and large difference in marginal costs.Under these circumstances, tighter patents reduce production cost inS, shifting outward that firm's reaction function and expandingexports to the Nmarket. Similar analysis finds that stronger IPR wouldincrease S's domestic production and imports from N would fall.However, in the case of small joint market size and small difference inmarginal costs, S activities would decline.

The intuition is that stronger patents in the South increase(decrease) the marginal benefit (marginal cost) of transferringknow-how, raising the amount transferred. Also, there are fixedcosts of technology transfer and it requires large market sizes toguarantee that the total surplus is positive. Under such circumstances,stronger technology protection would make the S firm morecompetitive in the international market.

3.3. N Firm's export or licensing decision

Assume imitative imports are not banned.Working back to the firststage of the game, N compares export profit with licensing profit indeciding the mode of entry. We determine k1, the threshold value ofIPR that induces licensing as the equilibrium outcome. This occurswhere the profit from licensing just equals that from export, or thejoint surplus in brackets in Eq. (6) is zero. Under our assumptions thisjoint surplus at k=0 is negative because the technology transfer costsare high and S's productivity gain is small, despite the low imitationcost. Further, the joint surplus at k=1 is positive. Finally, because thissurplus is non-decreasing in k, the threshold value lies between zeroand one.

There is no solution for this value under our general functionalforms for changes in costs of technology transfer, production andimitation. We therefore adopt specific functional forms that conformto our assumptions and calculate the threshold value of k.13 With thisspecification, N licensing profits follow an inverse-U shape in theamount of know-how transferred. These profits are maximized atsome x⁎b1, implying incomplete know-how transfer. Further, licen-sing profit rises throughout as patents are strengthened as long aslicensing is the equilibrium. However, this relationship is concave sothat the profit gain under licensing diminishes as k rises.

When patent protection gets sufficiently high S's imitation costwould be prohibitive. In that case, N exports to South and achieves a

13 These forms are listed in the mathematical appendix.

monopoly profit that exceeds its profit under duopoly with licensing.We find that monopoly is the equilibrium in this unblocked case if IPRexceeds a threshold value k

_NB, which depends on imitation costs and

absorptive ability. In the case where North blocks imitative imports,however, the corresponding IPR level at which S chooses not to imitateis k

_B. It is straightforward to show that k

_Bbk

_NBb1. In short, if the

North blocks imitative imports the altered payoffs deter licensing andsustain a full N monopoly at a lower level of Southern patent rights.

As noted above, we define k1 as the critical IPR value that induces ashift from exporting with imitation risk to licensing, assuming noimport blockage. Similarly, we define k2 as this critical IPR value whenthere is import blockage. It can be shown that k1bk2, so that the Northpolicy of banning imports deters imitation up to a higher level ofSouthern patent protection.

In Fig. 1 the horizontal lines represent N's export profits and theother curve represents profits from licensing.14 Thus, withoutblockage the equilibrium outcome is export with S imitation if0bkbk1, licensing if k1bkbk

_NB, and the export monopoly if k

_NBbkb1.

Note that the North import ban raises the lower critical level andreduces the higher critical level of Southern patent rights, shrinkingthe licensing range. Further, the N firm's profits are the same undereither import policy for an IPR level higher than k

_NB. Otherwise the

import ban favors N profits at any level of Southern patent strength.

3.4. A note on wage impacts

This is a partial-equilibrium model in which it is relativelystraightforward to describe wage effects of IPR policy.15 Assume thatlabor is the only factor of production and is in fixed supply. Let α bethe unit labor requirement for producing the good in the South, whereα declines with x. As the entry mode changes from exports tolicensing, the unit labor requirement decreases and total quantityproduced by S goes up. The first effect reduces labor demand but thesecond increases it and the latter impact dominates under asufficiently large increase in S market share. In the North the unitlabor requirement does not change while total quantity produced fallsin the shift from exporting to licensing, thereby reducing labordemand and the wage rate.

in IPR does not affect relative marginal costs, though it does reduce S profit throughhigher imitation costs.15 The mathematical appendix demonstrates these results.

235L. Yang, K.E. Maskus / Journal of Development Economics 90 (2009) 231–236

Once licensing is the equilibrium further strengthening of patentrights increases the S firm's market share. The increase in quantitydominates the reduction in labor requirement under large marketsizes, raising the Southernwage rate. Correspondingly, the Northwagerate falls as more know-how is transferred. Finally, when IPR getssufficiently strong that the S firm exits and N asserts a monopoly, theSouthern (Northern) wage rate declines (rises).

3.5. Alternative market assumptions

We offer brief comments on the robustness of our results toalternative market structures.16 First, suppose there are two N firmsbut one has a superior process technology. In this case the criticalSouthern patent value at which licensing is chosen becomes higherbecause the S firm has two technologies to imitate. Beyond this valuethe lower-cost N firm would undertake licensing and the extent ofknow-how transferred would rise with k. The marginal gain fromlicensing rises faster with k because it steals profits from the higher-cost N firm,making it possible for a greater amount of know-how to betransferred.

Second, suppose there are two S firms to which the single N firmcan license, giving it more bargaining power. Here the critical kinducing licensing is smaller than in the benchmark case and moreknow-how is transferred at every level of IPR in the licensing range.These results hold also when there is free entry into imitation in theSouth but N can license to a single firm. In this case the number of Simitators falls with k in the licensing range. Overall, our findingsremain qualitatively intact with different numbers of firms engagingin quantity competition.

Finally, return to two firms and suppose N and S compete in prices.Here either successful imitation or licensing permits S to capture thefull global market at a price just below N marginal cost. Again, acritical k exists above which N will sacrifice its production to gain ashare of higher licensing profits. Within the licensing range, increasesin patent strength do not affect S exports or price. While this case isperhaps less interesting analytically, it is consistent with firms fullyoutsourcing their production.

4. Welfare impacts of strengthened IPR

Welfare calculations in this context are complex and, to save space,we simply overview the results here.17 We consider the range of k inwhich there may be imitation or licensing because once IPR protectionbecomes sufficiently high that N is a monopolist, further increases areredundant.

For 0bkbk1, S competes through imitation. Here an increase inpatent rights reduces Southern well-being, defined as local consumersurplus plus the S firm's production profit, by diminishing the latter.Upon reaching k1 there is a discrete jump in Southernwelfare becausethe decision to license generates a positive know-how transfer,reducing S marginal cost and expanding competition and consumergains. Beyond this point, stronger patent rights have offsetting effects.First, this policy shift reduces technology-transfer costs and increasesthe proportion of know-how transferred under licensing. Theseimpacts increase S's profit and expand consumer gains from greatercompetition, with these effects being larger under higher localabsorptive capacity. Second, the higher imitation cost reduces thevalue of the S firm's outside option, decreasing its licensing profits.Southern welfare increases if the former effects dominate. In fact, thisoutcome pertains for a sufficiently small N bargaining share. In brief,for IPR reform to raise local welfare under licensing, S must have arelatively strong bargaining position. Similar analysis shows thatSouthern welfare increases unambiguously with a rise in local

16 Each of these claims can be readily proven analytically.17 Again, these computations are available in the mathematical appendix.

absorption capacity. Once the equilibrium regime becomes an Nmonopoly at the higher critical value of k Southern welfare fallsdiscretely to its lowest level and remains constant.

We can show further that Northern welfare rises with k in the lowrange because that policy decreases the threat of imitation, raising Nprofits. Upon reaching the licensing equilibrium range, strongerpatents both raise N profits and expand competition, increasingwelfare. In the high range of k, where a monopoly is established, theimpact depends on the net effect of higher N profits and lowerconsumer welfare. A specific result is that Northern welfare in themonopoly range exceeds that in the imitation range if market sizes arelarge.

Finally, global welfare rises with a stronger IPR regime in the Southunder licensing, so long as the condition in Eq. (8) holds. Recall thatthis condition requires the joint market size to be large and thedifference in post-transfer N and S marginal costs to be high. Thepolicy change decreases the technology-transfer cost and expandsknow-how transfers, thereby increasing competition and consumerwelfare. These effects outweigh any reduction in global profits. Anexpansion in absorptive capacity also increases global welfare byshifting more production to the South where marginal cost is lower.When the full N monopoly is reached, however, global welfare isdiminished in comparison with licensing. Thus, in this model fullprotection would not be globally optimal.18

A final note is that the welfare impacts of a Northern ban onimitative S imports vary by country. It reduces S profits underimitation and also diminishes the S firm's share of licensing profits.These factors dominate and Southern welfare is diminished byblocking throughout the range of k before the full monopoly isestablished. In contrast, this ban tends to raise Northern welfare byraising profits in the imitation range and achieving a higher profitshare in the licensing range.

5. Adding foreign direct investment

We now incorporate a simple specification of FDI into the model topermit a third important form of technology transfer. Suppose that theN firm has the option of creating an S subsidiary at a cost of g=γ+z(x).Here, γ is the fixed cost of setting up a plant and transferringtechnology, while z(x) is the variable transfer cost, which increaseswith the proportion of know-how transferred. Since the S subsidiary isfully owned by the N multinational firm, it has no incentive to imitate.However, the subsidiary faces imitation risk from a local firm at thesame cost as above.

In this setup, assuming sufficient market sizes the N firm wouldtransfer the full amount of know-how to its subsidiary.19 The essentialreason is that under FDI all profits are returned to N, rather thanshared under licensing. Accordingly, N transfers its full know-how toachieve the maximum reduction in production cost. Thus, in any FDIequilibrium the transfer cost g=γ+z(1) is constant and the marginalproduction cost of the S subsidiary firm becomes cDD=cS−r(1, a).Indeed, under FDI the N firm exits production altogether and servesboth markets from its subsidiary, another case of full offshoring.

Consider next the entry mode of the N firm. Compared to licensingit now has two possible reservation values in the bargaining game. Ifthe FDI transfer cost is less than the difference between productionprofits under FDI and production profits under exports, N choosestotal profits with the subsidiary (ΠDD) as its reservation value.Otherwise it chooses profits under production at home and export.To summarize, FDI involves a fixed setup cost but transfers know-howfully and achieves lowest marginal cost, while facing imitation risk.Licensing incurs a technology-transfer cost and generates partialknowledge transfer but does not face imitation risk.

18 See Grossman and Lai (2004) for additional insights.19 This claim is proven in the mathematical appendix.

236 L. Yang, K.E. Maskus / Journal of Development Economics 90 (2009) 231–236

Working through the profit functions we find the following results.For sufficiently high investment costs the reservation option for N isexports with imitation. That is the equilibrium for 0bkbk1, with theremaining equilibria as patent rights are strengthened the same asthose described earlier. For lower setup costs the equilibrium is FDIwith imitation for 0bkbkD, where kDNk1, with licensing occurring atyet-stronger patent rights before the monopoly ensues.

In essence the results of this simple model may be characterized asfollows. In countries where subsidiary setup costs are large and patentprotection is weak, the N firm competes through exports and acceptsthe risk of local imitation. In this case a tighter patent regimediminishes S profits and Southernwelfare. However, if these countriesstrengthen IPR they can induce a licensing equilibrium, which favors Slicensee exports and likely expands welfare. Alternatively, countrieswith weak patents but lower subsidiary setup costs are more likely toattract FDI than N exports. Here, as IPR are strengthened the imitativeS firm becomes a licensee and increases in k again expand localexports and well-being. The shifts from trade to FDI to licensing atvarious configurations of setup costs and patent rights are reminiscentof the literature on internalization and IPR (Markusen, 2001).

To complete the analysis, note that if the North governmentblocked imitative imports under FDI with imitation, the impact wouldbe to raise even further the minimum Southern IPR level at whichlicensing occurs and a diminution in the latter country's welfare.

6. Summary and conclusions

In this paper we developed a model of strategic competition tostudy the effects of stronger IPR protection in developing countries ontheir export performance, the mode of technology transfer andwelfare. By reducing the Southern firm's marginal cost related to thedegree of know-how absorbed, and also the cost of technologytransfer, patent reforms could expand export opportunities. We foundalso that Southern welfare could rise with both IPR and absorptivecapacity if S has relatively high bargaining power.

This model is stylized but offers insights into means by whichpolicymakers in developing countries might fashion their reforms inintellectual property. Specifically, stronger patent rights and tradesecrets are likely to expand exports and improve welfare if domesticfirms gain a more advanced ability to absorb and implement availableinternational technologies. A complementary policy is to reduce thecosts of establishing a subsidiary.

References

Branstetter, Lee, Fisman, Raymond, Foley, C. Fritz, 2005. Do stronger intellectualproperty rights increase technology transfer? Empirical evidence from U.S. firm-level panel data. Quarterly Journal of Economics 121, 321–349.

Branstetter, Lee, Fisman, Raymond, Foley, C. Fritz, Saggi, Kamal, 2007. Intellectualproperty rights, imitation and foreign direct investment: Theory and Evidence.NBER Working Paper, vol. 13033.

Diallo, Barrou, 2003. Historical perspectives on IP protection for software in selectedcountries worldwide. World Patent Information 25, 19–25.

Ginarte, Juan C., Park, Walter G., 1997. Determinants of patent rights: a cross-nationalstudy. Research Policy 26, 283–301.

Glass, Amy J., Saggi, Kamal, 1999. Intellectual property rights and foreign directinvestment. Journal of International Economics 56, 387–410.

Grossman, Gene M., Lai, Edwin L.C., 2004. International protection of intellectualproperty. American Economic Review 94, 1635–1653.

Hasan, Rana, Raturi, 2001. Does investing in technology affect exports? Evidence fromIndian firms. East-West Center Working Paper, vol. 21. May 2001.

Helpman, Elhanan, 1993. Innovation, imitation, and intellectual property rights.Econometrica 61, 1247–1280.

Kumar, Nagesh, Siddharthan, N.S., 1993. Technology, firm size and export behavior indeveloping countries: the case of Indian enterprises. UNU/INTECH Working PaperNo 9.

La Croix, Sumner J., Kawaura, Akihiko, 1996. Product patent reform and its impact onKorea's pharmaceutical industry. International Economic Journal 10, 109–124.

Lai, Edwin L.C., 1998. International intellectual property rights protection and the rate ofproduct innovation. Journal of Development Economics 55, 115–130.

Lai, Edwin L.C., Qiu, Larry D., 2004. The North's intellectual property rights standard forthe South? Journal of International Economics 59, 183–209.

Markusen, James R., 2001. Contracts, intellectual property rights and multinationalinvestment in developing countries. Journal of International Economics 53,189–204.

Maskus, Keith E., 2004. Encouraging Technology Transfer. Report for UNCTAD/ICTSDProject on Intellectual Property Rights and Sustainable Development, Issue Paperno. 7.

Smith, Pamela J., 2001. How do foreign patent rights affect U.S. exports, affiliate sales,and licenses? Journal of International Economics 55, 411–440.

Taylor, Scott M., 1994. Trips, trade, and growth. International Economic Review 35,361–381.

U.S. Department of Commerce, Bureau of Economic Analysis, 2007. U.S. InternationalServices: Cross-Border Trade 1986–2006 and Sales through Affiliates 1986–2005. athttp://www.bea.gov/international/intlserv.htm.

Vishwasrao, Sharmila, 1994. Intellectual property rights and the mode of technologytransfer. Journal of Development Economics 44, 381–402.

Vishwasrao, Sharmila, 2007. Royalties versus fees: how do firms pay for foreigntechnology? International Journal of Industrial Organization 25, 741–759.

Yang, Guifang, Maskus, Keith E., 2001. Intellectual property rights, licensing, andinnovation in an endogenous product-cycle model. Journal of InternationalEconomics 53, 169–187.