Industrial Policy, IPRs and International Policy Coordination in the Global Economy

International competition in vertically differentiated markets with innovation and imitation: Trade policy versus Free trade by E. Kovac and K. Zigic (2011)

The important characteristic of international competition between firms from developed and less developed countries is vertical product differentiation, where firms' quality choices are strategic decisions. The authors consider a model with sequential quality choice and the possibility of imitation, and compare positive and normative aspects of this setup in free trade and under strategic trade policy. In particular, they identify conditions under which trade policy can initiate a quality reversal (a change in the quality ladders) and demonstrate that they are closely related to improvements in domestic welfare. Otherwise, commitment to free trade can be an optimal trade arrangement.

Endogenous Market Structures and Strategic Trade Policy by F. Etro (2009, International Economic Review).

What are the strategic advantages that export promoting policies create for domestic firms? What is the optimal trade policy with respect to exporting firms? How much should we invest to promote international demand of domestic products? Do competitive devaluations give a real advantage to national firms in the foreign markets? This paper provides a unified framework to rethink about the real advantages of the policies of export promotion both in terms of trade policy and exchange rate policy.

Common wisdom on the benefits of export subsidization largely departs from the implications of trade theory. Governments strongly support exporting firms, they often hide forms of export promotion behind nationalistic pride, and consider the conquer of larger market shares abroad as a positive achievement in itself. The European Union coordinates trade between its members and the rest of the world in a similar spirit, and subsidizes exports of agricultural products and the aircraft industry (Airbus is probably one of the main examples of strategic trade policy). France is use to support its “national champions” with public funding. Italy has a long tradition of public support of the “Made in Italy”. Japan, Korea and other East-Asian countries have implemented export promoting policies for decades. Heavily protected South-American countries have tried to subsidize manufactured products in which they could develop a comparative advantage (and not only those). Even US has implemented strong forms of export subsidization through tax exemptions for a fraction of export profits, foreign tax credit and export credit subsidies. It appears quite surprising that, in front of this, trade economists do not have clear and unambiguous arguments to explain why export subsidies could be the optimal unilateral trade policy. I provide such an argument, studying a model of trade policy for a foreign market with free entry for international firms. Notice that free entry is a realistic assumption since a foreign country without a domestic firm in the market can only gain from allowing free entry of international firms. Under free entry, export subsidization is always the best unilateral policy both under quantity and price competition, or, more generally, under strategic substitutability and strategic complementarity. The intuition is simple. While firms are playing some kind of Nash competition in the foreign market, a government can give a strategic advantage to its domestic firm with an appropriate trade policy. When entry is free, an incentive to be accomodating is always counterproductive, because it just promotes entry by other foreign firms and shifts profits away from the domestic firm. It is instead optimal to provide an incentive to be aggressive, that is to expand production or (equivalently) lower the price, since this behaviour limits entry increasing the market share of the domestic firm. This is only possible by subsidizing its exports.

Last but not least, governments undertake competitive devaluations with the specific aim to support exporting firms. In spite of this, economic theory is again ambiguous on the merits of these policies. Following the pioneeristic work by Dornbusch (1987), I evaluate the strategic incentives to exchange rate devaluations in a model where the shift of exchange rate variations on prices is endogenous. Strategic effects of devaluations emerge only when firms produce at home, not if they directly produce in the foreign market. While under barriers to entry competitive devaluations may be a bad idea to provide a strategic advantage to domestic exporters, especially under price competition, under free entry there is always a strategic incentive to depreciate the currency to promote exports. The rationale behind all these forms of exports promotion is always the same as long as the adoption of these policies helps the domestic firm to be aggressive in the foreign market, which is always the case when entry is free in this market. Ultimately, the scope of export policy is just to conquer market shares abroad and shift profits from firms of other countries toward domestic firms. If we interpret globalization as the opening up of new markets to international competition we can restate the main result as follows: in a globalized word, there are strong strategic incentives to conquer market shares abroad by promoting exports.

Competition and Privatization Policy: The Relative Performance Approach by T. Matsumura and M. Okamura (2009).

This note investigates the relationship between competition and privatization policies. Existing works measured the toughness of competition by the number of firms and showed that the optimal degree of privatization is higher when the number of firms is larger. We adopt the relative profit approach where each firm maximizes the relative profit rather than their own profit, and the resulting competition becomes tougher when firms care about the rivals’ profit more. The authors find that the optimal degree of privatization is smaller when each firm cares about the rival’s profit more (so the market competition is tougher).

Globalization, Rent Protection Institutions, and Going Alone In Freeing Trade by W.-H. Grieben and F. Şener (2008).

This paper presents a two-country North-South product cycle model of trade and non-scale growth to explore the growth and relative-wage effects of two forms of globalization – an expansion of the relative size of the South and unilateral trade liberalization by either country. Both Northern innovation and Southern imitation are endogenously determined. The authors find that the location of rent protection institutions and the sectoral trade structure determine whether or not globalization raises steady-state economic growth. They demonstrate that for accelerating worldwide economic growth, contrary to conventional wisdom, unilateral Northern trade liberalization is preferable to bilateral trade liberalization.

Changing the Research Patenting Regime: a Schumpeterian Explanation by G. Cozzi and S. Galli (2007).

This important paper provides a new theoretical and empirical argument in favor of the extension of patentability to basic research findings of general interest for sequential innovations.

Innovation economics recognizes sequentiality as a distinctive characteristic of the innovative process. Among them Susanne Scotchmer (1991) argued that "Most innovators stand on the shoulders of giants, and never more so than in the current evolution of high technologies, where almost all technical progress builds on a foundation provided by earlier innovators. For example, most molecular biologists use the basic technique for inserting genes into bacteria that was pioneered by Herbert Boyer and Stanley Cohen at the early 1970s, (...). In pharmaceuticals, many drugs like insulin, antibiotics, and anti-clotting drugs have been progressively improved as later innovators bettered previous technologies." Scotchmer’s words do not miss to highlight that sequentiality plays a central role in advanced biotechnologies. According to Roger Brent, the head of Molecular Sciences Institute of Berkeley, in this field, the recent expiring of the U.S. patent on polymerase chain reaction (a genetic procedure patented by F. Hoffman-La Roche and used in almost all research fields of life sciences) will have terrific consequences on research by raising the expectation of discovering new drugs for tropical diseases.

Several studies in the law and economics of intellectual property documented how, over the last 25 years, U.S. Court decisions switched from the traditional jurisprudential limitation of the patentability of early-stage scientific findings lacking in current commercial value to the conception that also fundamental basic scientific discoveries with no current tradeable application (such as scientific theories, algorithms and genetic engineering procedures) fall in the general applicability of the patent system design. For example, in 1980, in the Diamonds v. Chakrabarty case, the Supreme Court of United States ruled that microorganism produced by genetic engineering could be patented. The Supreme Court’s decision arrived two years before the introduction of the first commercial product, human insulin, obtained with recombinant DNA techniques. Jensen and Thursby (2001) study the licensing practices of 62 US universities. They find that "Over 75 percent of the inventions licensed were no more than a proof of concept (48 percent with no prototype available) or lab scale prototype (29 percent) at the time of license!". Moreover, most of the inventions licensed were in such an embryonic state of development, that no one could estimate their commercial potential and the inventor’s cooperation was required to get a successful commercial development.

Universities and public laboratories have always been the main performers of basic R&D in the United States and in Europe. Though an important reason for the relatively low private contribution to basic R&D is often found in the high degree of uncertainty that this activity involves in terms of future commercial application and success, the legal permission to appropriate the fruits of years of investigations is making a big difference between post-1980 US and current European innovation systems. If basic findings are not patentable, as was in the pre-Eighties US and in the current EU regime, the publicly funded researchers or the university professors will likely investigate undirected by the profitability concerns. Therefore they may end up with discovering economically useless ideas, as a response to the random nature of their personal intellectual interests. Allowing them to patent scientific findings would introduce an interface between intellectual speculation and consumer needs, thereby channelling scientific investigation in the direction more demanded by the economy. Hence the post-Eighties US patenting regime allows its national system of innovation to count on a maximum flow of basic research findings per researcher. Instead, in the pre-Eighties US or in a European patenting regime, a smaller fraction of the scientists’ discoveries would be useful for further commercial applications. On the other side, the patentability of early-stage ideas, by granting monopolistic rents on basic discoveries charges a heavier burden on the applied R&D industry, which restricts the licensing decision of the research tool patent holders. This shifts the debate on the merits of public basic research over private basic research from appropriability concerns to other issues, as, for instance, the organization and the objectives of research activity and the monetary and non monetary incentives guiding research activity in the two systems.

Despite this controversial aspect of the innovation and growth policy, in the standard Schumpeterian growth theory each R&D firm is assumed to undertake an independent innovation process in order to produce a probability of discovering an idea whose value immediately transfers into a tradeable application in the form of higher quality products. Of course, the Schumpeterian growth theory acknowledges the intertemporal spillover and the sequentiality for marketable products. However, it cannot handle the many real world cases in which ideas have to undergo a gradual development process before becoming embodied in a saleable technology, and R&D firms gain an experience in multiple-stage research activities before developing tradeable applications of basic scientific findings. Thus, the conception that only the concrete embodiment of an idea is provided of economic value prove too restrictive in an age in which a large part of the international academic community, jointly with a large part of the R&D business community, expresses the need for an appropriate intellectual property design to take into account both the sequential and cumulative nature of ideas and the change in the technological paradigm determined by the biotechnology industry. This paper, by taking the R&D sequentiality into the Schumpeterian paradigm investigates the relation between the cumulative uncertainty involved in the two-stages innovation process and the inefficiency in the public university system. The authors consider the lack of research direction of large scale publicly funded R&D, but also the ability of public laboratories to coordinate their activities better than the freely entrant private laboratories of the scenario with patentable research tools. Similarly, the positive incentives to basic research set by the possibility to patent research tools will be contrasted by the monopolistic underinvestment in the applied R&D. The model therefore tries to give an impartial, albeit stylized, representation of the debated issue of the desirability of the patentability of research tools. Whether the positive or negative effects of the post- Eitghies US patent system prevail depends on the data. The paper performs a numerical attempt to evaluate the desirability of the US regime change in the early Eighties, by plugging the available data on technology, employment and skill premium into the model. After estimating the crucial R&D productivity parameters for the Seventies, the authors run the model for the two opposite institutional scenarios. They find that during the Seventies the old system was losing grounds on the perspective new patenting system, and the US authorities took institutional decisions which allowed a more efficient innovative activity. A crucial role was played by the steadily decreasing productivity of applied R&D, which is estimated in a novel way. Other studies documented an increasing complexity in the applied R&D activity as well. If applied R&D becomes increasingly more complicated, it is important to have a large flow of half-ideas from basic research. This implies that the inefficiency of public R&D has to be removed more urgently. The authors claim that this justified the reform undertaken in the US around 1980 andmight recommend similar modifications in the European patent law.

Contractual Versus Generic Outsourcing: The Role of Proximity by R. Feenstra and B. Spencer (2006).

This article explores the relationship between proximity of buyers and sellers and the organizational form of outsourcing. Outsourcing can be “contractual” in which suppliers undertake specific investments or can involve “generic” market transactions. Both proximity and foreign-worker skill expand the range or variety of products that are contractually outsourced abroad relative to the range of generic imports. Using measures of distance to capture proximity, the authors find support for these predictions using data for ordinary versus processing exports from Chinese provinces to destination markets. They also find support for the predictions of an extended model that allows for multinational production.

International competition in vertically differentiated markets with innovation and imitation: Impacts of trade policy by E. Kovac and K. Zigic (2006).

This paper analyzes the domestic welfare implications of trade policies in a less developed or transition country whose firm competes with the firm from a developed country in the domestic market. The important characteristic of such competition is vertical product differentiation, where the quality choices represent strategic decisions of the firms. Compared to the previous literature, the authors introduce leadership, and possibility of imitation and learning by the domestic firm. They identify conditions under which the phenomenon of so called quality reversal takes place.

Trade Policy, Market Leaders and Endogenous Competition Intensity by J. Boone, D. Ianescu and K. Zigic (2006).

It has been shown that in imperfectly competitive markets tariff policy can alleviate the negative consequences of breaching the intellectual property rights by Southern firms on a Northern country’s social welfare. Yet, the overall positive effect of tariff protection is achieved at the consumers’ expense. These results have been derived in setups that model the imperfect competition using either Bertrand or Cournot type of competition. In addition, the initial asymmetries between the Northern and Southern firms in these models have no impact on the nature of market conduct (or, in jargon, the “toughness of competition” is given exogenously). However, there is convincing evidence that the presence of firm asymmetries might affect the market conduct in two ways. First of all, the nature or toughness of market competition might be endogenously induced by the level of cost, capacity or capital asymmetry that exists among firms. Secondly, firm differences may induce a firm or a group of firms to assume the role of the leader in the market. When firm asymmetries determine the market conduct and market leadership, positive tariffs may play additional roles than in traditional models of imperfect competition. This paper shows that this is indeed the case using a setup in which a group of firms play a role of leaders and firm asymmetries determine the strength of market competition. The results suggest that tariffs set to protect domestic firms may depress the market price and increase consumer surplus.

The authors introduce asymmetries as differences between firms’ efficiency levels and model a situation in which both domestic and foreign firms supply a domestic market. Domestic (Northern) firms are more cost efficient due to their ability to innovate. Foreign (Southern) firms do not have such ability but they copy, although imperfectly, the results of Northern R&D. To protect domestic producers against the negative externality the Northern government might introduce tariff duties. The government’s decision is based on a social welfare function that generally assigns different weights to its three components (domestic firms’ profits, consumer surplus, and government revenue). Consumers benefit from tariff policy and governments that assign a high enough weight to the consumer surplus set positive tariff levels. Under protection the innovation level remains the same as under free trade but the average industry efficiency increases. The policy induced equilibrium is in line with Sutton’s notion of “toughness of price competition”. Namely, the higher market concentration implies tougher price competition compared with the lower market concentration and softer intensity of competition when all (domestic and less efficient foreign) firms are active in equilibrium. This is because the threat that the remaining firms will enter the market presses the domestic firms to keep prices low. Much like in the Etro model of market leaders faced with the threat of entry, firms that act as leaders in the market behave aggressively and undertake actions (such as pricing aggressively here or overinvestment in strategic variable there) that lead them to charge lower prices than their followers.

Strategic Export Promotion by F. Etro (2006).

What are the strategic advantages that export promoting policies create for domestic firms? What is the optimal trade policy with respect to exporting firms? How much should we invest to promote international demand of domestic products? Do competitive devaluations give a real advantage to national firms in the foreign markets? This paper provides a unified framework to rethink about the real advantages of the policies of export promotion both in terms of trade policy and exchange rate policy.

Common wisdom on the benefits of export subsidization largely departs from the implications of trade theory. Governments strongly support exporting firms, they often hide forms of export promotion behind nationalistic pride, and consider the conquer of larger market shares abroad as a positive achievement in itself. The European Union coordinates trade between its members and the rest of the world in a similar spirit, and subsidizes exports of agricultural products and the aircraft industry (Airbus is probably one of the main examples of strategic trade policy). France is use to support its “national champions” with public funding. Italy has a long tradition of public support of the “Made in Italy”. Japan, Korea and other East-Asian countries have implemented export promoting policies for decades. Heavily protected South-American countries have tried to subsidize manufactured products in which they could develop a comparative advantage (and not only those). Even US has implemented strong forms of export subsidization through tax exemptions for a fraction of export profits, foreign tax credit and export credit subsidies. It appears quite surprising that, in front of this, trade economists do not have clear and unambiguous arguments to explain why export subsidies could be the optimal unilateral trade policy. I provide such an argument, studying a model of trade policy for a foreign market with free entry for international firms. Notice that free entry is a realistic assumption since a foreign country without a domestic firm in the market can only gain from allowing free entry of international firms. Under free entry, export subsidization is always the best unilateral policy both under quantity and price competition, or, more generally, under strategic substitutability and strategic complementarity. The intuition is simple. While firms are playing some kind of Nash competition in the foreign market, a government can give a strategic advantage to its domestic firm with an appropriate trade policy. When entry is free, an incentive to be accomodating is always counterproductive, because it just promotes entry by other foreign firms and shifts profits away from the domestic firm. It is instead optimal to provide an incentive to be aggressive, that is to expand production or (equivalently) lower the price, since this behaviour limits entry increasing the market share of the domestic firm. This is only possible by subsidizing its exports.

Last but not least, governments undertake competitive devaluations with the specific aim to support exporting firms. In spite of this, economic theory is again ambiguous on the merits of these policies. Following the pioneeristic work by Dornbusch (1987), I evaluate the strategic incentives to exchange rate devaluations in a model where the shift of exchange rate variations on prices is endogenous. Strategic effects of devaluations emerge only when firms produce at home, not if they directly produce in the foreign market. While under barriers to entry competitive devaluations may be a bad idea to provide a strategic advantage to domestic exporters, especially under price competition, under free entry there is always a strategic incentive to depreciate the currency to promote exports. The rationale behind all these forms of exports promotion is always the same as long as the adoption of these policies helps the domestic firm to be aggressive in the foreign market, which is always the case when entry is free in this market. Ultimately, the scope of export policy is just to conquer market shares abroad and shift profits from firms of other countries toward domestic firms. If we interpret globalization as the opening up of new markets to international competition we can restate the main result as follows: in a globalized word, there are strong strategic incentives to conquer market shares abroad by promoting exports.