How Stronger Protection of Intellectual Property Rights Affects International Trade Flows

Author:Carsten Fink/Carlos A. Primo Braga

    This paper is adapted from an earlier version published as Policy Research Working Paper 2051 by the World Bank in 1999. Comments and assistance from Azita Amjadi, Clive Bell, Raed Safadi, and Christoph Schmidt are gratefully acknowledged.

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I Introduction

Intellectual property rights (IPRs) affect international trade flows when knowledge-intensive goods move across national boundaries. The importance of IPRs for trade has gained more significance as the share of knowledge-intensive or high-technology products in total world trade has doubled between 1980 and 1994 from 12 percent to 24 percent.1 At the international level, IPRs have traditionally been governed by several conventions-most prominently the Paris Convention for patents and trademarks and the Berne Convention for copyrights- which are administered by the World Intellectual Property Organization (WIPO). In the 1980s, mounting disputes over IPRs led to the inclusion of trade-related IPRs on the agenda of the Uruguay Round of multilateral trade negotiations. The resulting Agreement on Trade-Related Aspects of Intellectual Property Rights,Page 20 (TRIPS) of 1994 represents the most far-reaching multilateral agreement toward global harmonization of IPRs.2

Several studies have attempted to estimate the extent to which IPRs relate to trade. Maskus and Penubarti (1995) use an augmented version of the Helpman-Krugman model of monopolistic competition to estimate the effects of patent protection on international trade flows. Their results indicate that higher levels of protection have a positive effect on bilateral manufacturing imports into both small and large developing economies. These results are confirmed by Primo Braga and Fink (1997), whose results for a similar model showed the same positive link between patent protection and trade flows.

This study provides new evidence regarding the effects of patent protection on international trade. It uses a gravity model of bilateral trade flows and estimates the effects of increased protection on a cross section of 89 by 88 countries. It improves on previous studies in two respects. First, we estimate the gravity model for two different kinds of aggregates: total nonfuel trade and high-technology trade. Moreover, we address the problem of zero trade flows between countries by adopting a bivariate probit model. Second, to measure the strength of IPR regimes, we use a fine-tuned index on national IPR systems developed by Park and Ginarte (1997). Our results confirm previous findings suggesting a positive link between IPR protection and trade flows for the aggregate of nonfuel trade. However, IPRs are not found to be significant for high-technology trade flows.

The next sections provide a summary of theoretical considerations, present the estimation setup, report the results obtained, and compare our results to related studies.

II A Review of the Economics of Trade-Related IPRs

The conventional economic rationale for the protection of IPRs in closed economies can be found in Arrow (1962). Because knowledge is nonrival in consumption, it should be freely available (apart from the cost of transmitting it). If it were freely available, however, the market would underinvest in the production of new knowledge because innovators would not be able to recover their costs. By granting innovators the exclusive rights to commercialize their intellectual assets over a certain period of time, IPRs offer an incentive for the production of knowledge. In short, IPRs introduce a static distortion (that is, access to proprietary knowledge is sold above its marginal cost), which is rationalized as an effective way to foster the dynamic benefits associated with innovative activities.

IPRs are territorial in character-that is, they are created by national laws and differ across countries. If intellectual property embedded in goods and services Page 21 originating in country A crosses the border to country B, two questions arise. First, how will IPR protection in country B affect the magnitude of the bilateral trade flow from country A to country B? Second, what are the implications of such protection on the economic welfare of both countries?

Bilateral Trade Flows and Differences in IPR Protection

IPRs affect international trade flows in several ways. For example, a firm may be deterred from exporting its patented good into a foreign market if potential "pirates" can diminish the profitability of the firm's activity in that market because of a weak IPR regime. Accordingly, strengthening a country's patent regime would tend to increase imports as foreign firms face increasing net demand for their products, reflecting the displacement of pirates. A firm might choose to reduce its sales in a foreign market as a response to stronger IPR protection because of its greater market power in an imitation-safe environment. These opposing market expansion and market power effects imply that the overall effect of IPR protection on bilateral trade flows is theoretically ambiguous (Maskus and Penubarti 1995).

A further source of ambiguity stems from the fact that differing levels of IPR protection may affect a firm's decision about its preferred mode of serving a foreign market. A firm may choose to serve a foreign market by foreign direct investment (FDI) or by licensing its intellectual asset to a foreign firm instead of exporting the product in an environment characterized by strong IPRs (Ferrantino 1993).3 Thus, strengthened IPR protection may have a further negative effect on trade flows in this respect.

Welfare Implications

The implications of tighter IPRs for economic welfare are complex. The simple fact that trade flows rise or fall in response to tighter IPRs is not sufficient for drawing conclusions regarding economic welfare. Both static and dynamic effects need to be considered. Moreover, in this chapter, we are primarily concerned with the effects of IPRs on international trade flows. In a different paper (Primo Braga and Fink 1997), we discuss how tighter IPRs affect economic welfare through FDI, the transfer of technology, and domestic research and development (R&D). The following paragraphs summarize the static and dynamic costs and benefits for two trading economies that may arise only in response to changes in trade flows fostered by stronger IPRs.

From a static partial equilibrium point of view, the source country of the trade flow is likely to gain from tighter protections, because it can capture increased Page 22 monopoly profits from the sale of its goods abroad. In contrast, the static effects on the welfare of the destination country are likely to be negative: increased market power by foreign title holders generates deadweight losses.4 Taking this view, many small, innovation-consuming countries fear that increased patent protection will only lead to a rent transfer to industrial, innovation-producing countries.5

From a static general equilibrium point of view, tighter IPRs tend to be further detrimental to the destination country of the trade flow because the reallocation of production-that is, the shift of product lines from the destination country to the source country-worsens the terms of trade in favor of the source country. In addition, the reallocation of production may reduce welfare in both countries as efficiency considerations call for an allocation of manufacturing to the region with lower costs.6 This effect may be of particular relevance if one recalls that most countries that have weak IPRs are low-wage, developing countries. At the same time, the welfare implications resulting from the reallocation of production may be partly offset by increased production through foreign subsidiaries (that is, FDI).

From a dynamic point of view, the introduction of IPRs stimulates innovation in the source country and thus increases future trade flows. That effect is beneficial for both trading economies, assuming that social returns on the innovations exceed private returns.7 The international recognition of IPRs also can be seen as an adjustment mechanism that guarantees dynamic competition between countries. Through IPRs, innovation-producing countries have an incentive to develop new technologies, which in their next generation are manufactured by follower countries. This mechanism thus leads to continued technological progress and economic growth and, from a dynamic point of view, is beneficial for both leaders and followers (Fisch and Speyer 1995).

In sum, the overall effect of IPR protection on levels of bilateral trade flows is ambiguous. From a static welfare point of view, IPRs can be viewed as a rent transfer mechanism that worsens the international allocation of production. Most studies conclude that the destination country loses from tighter protection, whereas the source country is usually better off (see, for example, Chin and Grossman 1988; Deardorff 1992; and Helpman 1993). However, benefits of a dynamic nature can be identified for both trading partners. On average, it is not clear whether these dynamic benefits can compensate for the static losses in the countries strengthening their IPR systems and whether tighter IPRs improve world economic welfare through their effect on trade flows. It is worth pointing out that these theoretical considerations may be dominated by political economy considerations, which have been clearly in favor of higher standards of protection over the past decades.8

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III Empirical Analysis: The Estimation Setup

To empirically estimate the effects of increased patent protection on bilateral trade flows, we use a conventional gravity model. Gravity models have been applied...

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