Trade liberalization, absorptive capacity and the protection of intellectual property rights

• Author: Arghya Ghosh,Jota Ishikawa
• DOI: http://doi.org/10.1111/roie.12367
• Date: 01 November 2018
• Published date: 01 November 2018

Rev Int Econ. 2018;26:997–1020. wileyonlinelibrary.com/journal/roie

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997

© 2018 John Wiley & Sons Ltd

DOI: 10.1111/roie.12367

SPECIAL ISSUE PAPER

Trade liberalization, absorptive capacity and the

protection of intellectual property rights

Arghya Ghosh1

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Jota Ishikawa2,3

1School of Economics,University of New

South Wales, Sydney, Australia

2Faculty of Economics,Hitotsubashi

University, Kunitachi, Japan

3RIETI, Tokyo, Japan

Correspondence

Jota Ishikawa, Faculty of Economics,

Hitotsubashi University, Kunitachi, Tokyo

186-8601, Japan.

Email: jota@econ.hit-u.ac.jp

Abstract

We examine how trade liberalization affects South’s in-

centive to protect intellectual property rights (IPR) in a

North–South duopoly model where a low‐cost North firm

competes with a high‐cost South firm in the South market.

The North firm serves the South market through either ex-

ports or foreign direct investment (FDI). The extent of ef-

fective cost difference between North and South depends

on South’s imitation, which in turn depends on South’s

IPR protection and absorptive capacity and North firm’s

location choice, all of which are endogenously determined

in our model. For a given level of IPR protection, South’s

absorptive capacity under exports may be greater than

under FDI. Even though innovation is exogenous to the

model (and hence unaffected by South’s IPR policy),

strengthening IPR protection in South can improve its

welfare. The relationship between trade costs and the de-

gree of IPR protection that maximizes South welfare is

non‐monotone. In particular, South has an incentive to

protect IPR only when trade costs are moderate. When

masking technology or licensing is incorporated into the

model, however, some protection of IPR may be optimal

for South even if the trade costs are not moderate.

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INTRODUCTION

Globalization leads to technology transfers/spillovers from developed countries (North) to develop-

ing countries (South). A typical channel of technology transfers/spillovers is trade and foreign direct

investment (FDI), which make it easier for South firms to imitate superior production technologies

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GHOSH and ISHIKAWA

in North. However, such imitation is neither automatic nor costless (Grossman & Helpman; 1991;

Helpman; 1993; Branstetter & Saggi; 2011). The extent of imitation depends crucially on South’s

absorptive capacity, that is South’s ability to effectively copy the superior technologies of North.

South’s imitation activities are also importantly affected by South government’s policies and North

firms’ strategic decisions (e.g., location). In particular, imitation is strongly influenced by the strength

of intellectual property rights (IPR) protection in South. If IPR protection is perfect and fully en-

forced, patented technologies cannot freely be copied. When IPR protection is imperfect, North firms

may mask their technologies to deter South firms from copying them unless masking is too costly.

Furthermore, North firm’s location choice affects South’s imitation, because geographical proximity

plays an important role in technology spillovers (see, for example, Eaton & Kortum; 1999; Branstetter,

2001; Keller, 2002; Bilir, 2014). When North firms serve the South market, South’s imitation is easier

under FDI than under exports.

In this paper, we examine South’s incentive to protect IPR in a North–South duopoly model where

a low‐cost North firm competes with a high‐cost South firm in the South market. The extent of effec-

tive cost difference between North and South specifically depends on South’s imitation. As discussed

above, imitation depends on North firm’s location choice, its masking decision, South’s absorptive

capacity (or, absorptive ability) and most importantly South’s IPR protection, all of which are endog-

enously determined in our framework.

Strengthening IPR protection boosts innovation. While that argument is well understood, critics of

stronger IPR regimes in South argue that there is little appreciable effect of IPR protection in South on

North innovation (Branstetter & Saggi, 2011). Furthermore, as argued by Maskus (2000) and Maskus

and McDaniel (1999), imposing a strong IPR regime might retard industrial development of the de-

veloping countries. Taking these arguments seriously, we assume that North innovation, which is

presumably the source of North’s cost advantage, is exogenously given. Instead, we incorporate North

firm’s other decisions (e.g., location choice and masking behavior) into our model and show that in-

corporating these features and endogenizing South firm’s imitation efforts to establish absorptive ca-

pacity have important IPR policy implications for South. In particular, we show that South can benefit

from strengthening its own IPR protection even when North innovation is unaffected by its IPR policy.

To make our analysis tractable, we assume that the trade liberalization is caused by a decrease in

trade costs, which is beyond the control of the South government. That is, trade costs are declining

as the result of a decrease in transport costs and a pre‐commitment to the reduction of trade barriers.

Hence, the policy instrument the South government can freely set is only the degree of IPR protection.

We find that the relationship between trade costs and South’s incentive to protect IPR can be subtle. In

particular, we show that trade liberalization can mute or amplify the North–South conflict regarding

IPR protection, depending on the trade costs.

To understand our implications better, we present more details of our North–South duopoly model.

A North firm (firm N), in our framework, has zero cost of production while a South firm (firm S) starts

with unit cost c(>0). Given trade costs, the South government chooses the level of IPR protection

α ∈ [0,1] where α = 0 implies full protection of IPR while α = 1 implies no protection of IPR. The

strength of IPR protection declines as α increases. Following South government’s choice of α, firm N

decides whether to export to South market or serve it via FDI. If firm N opts to export to South market,

it incurs a trade cost of t per unit. After the firm N’s decision has been made, firm S chooses the level

of imitation efforts, that is the level of investment C(z) in absorptive capacity which reduces its unit

cost from c to c(1 − αz) (where z ∈ [0,1]). As imitation is easier with FDI, we assume that C(z) is

lower under FDI.

Given that Cournot analysis is standard, let us start with the exports versus FDI decision. If firm

N chooses FDI, it avoids per unit trade cost. However, FDI makes the absorption of new technology