21

The Effects of the Strength of Intellectual Property
Rights Protection on Cooperative R&D between
Vertically Related Firms
Research Fellow : Akira Ishii

This study considers two vertically related industries, intermediate goods producers and final goods
producers, and makes an economic theoretical investigation of the effect that the strength of the protection of
intellectual property rights (IPRs) has on cooperative R&D between final goods producers and intermediate
goods producers. The focus is on the effects of IPRs on vertical cooperative R&D as strengthened IPRprotection reduces the degree of R&D spillover. R&D spillover is the use of technology and knowledge byparties other than the inventor without payment of remuneration. The results supported the following
conclusions. Vertical cooperative R&D promotes technological improvement regardless of the effectiveness of
IPRs at ensuring the appropriability of the technology. However, when IPR protection is strong, R&D
investment in vertical cooperative R&D may be excessive from the perspective of social welfare and joint
profits of all firms in the two vertical industries. This means that when IPR protection is strengthened,
conducting vertical cooperative R&D does promote technological improvement, but does not necessarily
increase the joint profits and social welfare.

1

Introduction of this research

The purpose of this research is toinvestigate the impact of the strength ofprotection of intellectual property rights(IPRs) on cooperative R&D between verticallyrelated firms using an economic theory
approach. A vertical relationship between
firms refers to the relationship between a
producer of final goods that are sold toconsumers and a producer of intermediate
goods, such as components and materials
required for production. For example, anautomobile assembly manufacturer and an
automobile parts manufacturer are verticallyrelated firms.
The intellectual property (IP) system is asystem that grants an exclusive right for use oftechnology in exchange for making thetechnology public. However, protection by an
IPR is not perfect, and it is difficult to takeexclusive possession of all benefits gained fromthe technology. The degree of appropriability
afforded by an IPR depends on the strength of
IPR protection. The strength of IPR protection
is not simple, but involves various factors
including the technical scope subject toprotection, the length of the term of protection,and ease of enforcement (ease of demanding an
injunction or claiming damages, the degree of
penaltiesforinfringement).
Meanwhile,
technologies outside the scope of IPR protection
and know-how are also often useful fordevelopment of new products or new processes

IIP Bulletin 2005

and bring benefits to other firms. Such asituation where technology or knowledge
developed through R&D, whether or notprotected by an IPR, is used by parties otherthan the inventor without payment of
remuneration is called R&D spillover. R&D
spillover occurs, for example, in the following
five cases. The first is when a patented
technology is published, other firms develop
similar technologies that do not conflict with thepatent right. These are called circumventing
inventions. For the second case firms can learn
about other firms' technology and knowledge byreverse engineering, meaning disassemblingand studying new products. The third caseoccurs when research results published at an
academic meeting or in a research paper serve
as reference material for researchers of otherfirms. The fourth case occurs when intermediate
goods users can utilize intermediate goods that
embody other users' technology and knowledge
by purchasing such intermediate goods ascomponents and materials. The fifth type of
spillover occurs when a researcher changes
jobs and contributes to the new firm by using
abilities developed at the previous firm. The
degree of such R&D spillover will decline if IPR
protection is strengthened. Therefore, thisresearch focuses on the impact that thestrength of IPR protection has on verticalcooperative R&D through changes in the
degree of R&D spillover, and develops
discussions based on the idea that the degree of
R&D spillover declines if IPR protection is● 154 ●

strengthened (*1) . R&D spillover can be divided
into four types: horizontal spillover between final
goods producers; horizontal spillover between
intermediate goods producers; vertical spilloverfrom a final goods producer to an intermediate
goods producer; and vertical spillover from anintermediate goods producer to a final goods
producer. It is often pointed out that a close
relationship between the final goods producer andintermediate goods producer is extremely
important for success in technology innovation.
For the intermediate goods producer, learning
the needs of the final goods producer is useful fordeveloping and producing components andmaterials. On the other hand, for the final goods
producer, information on new components andmaterials is useful for introducing newintermediate goods at an early stage. Therefore,
vertical spillover is likely to occur between a final
goods producer and an intermediate goods
producer that trade intermediate goods.
Cooperative R&D is most frequently observed
between a final goods producer and anintermediate goods producer. This is because
objectives and interests tend to coincide better
between vertically related firms than between
firms competing in a product market.
Implementation of vertical cooperative R&D
involves profits and risks. A final goods producer
and an intermediate goods producer caninternalize the externalities of vertical R&D bymaking decisions on R&D in concert, and can
avoid redundant R&D by sharing usefulknowledge. At the same time, the firms
participating in vertical cooperative R&D fear
horizontal spillover to rival firms, as well as therisk that rival firms will obtain a free ride bytrading for intermediate goods from the R&D
counterpart based on the R&D knowledge fromthe firm.
This research first theoretically analyzes theeffects of vertical cooperative R&D in a casewhere R&D spillover occurs. Then, based on theanalysis results, it examines the impact of thestrength of IPR protection on vertical cooperative
R&D.

2

Basic model

Section 2 introduces the basic model fortheoretically analyzing the effects of verticalcooperative R&D in a case where R&D spillover
occurs. Two industries having a vertical
relationship are assumed. In each industry, there
are two symmetric firms. Symmetric firms are
firms that have the same cost structure for R&D
and production. The firm in the downstream
industry will be called a downstream firm and thatin the upstream industry will be called an
upstream firm. Both upstream firms produce anintermediate good that are required for producing
a final good, and sell it to the downstream firms inthe market. Both downstream firms produce thefinal good using the intermediate good, and sell it
to consumers. The downstream firms use one
unit of the intermediate good to produce one unitof the final good. The respective downstream
firms are assumed to purchase the same quantityof the intermediate good from both upstream
firms.
Firms conduct R&D in order to reduce themarginal production cost. The marginal
production cost is the additional cost required forincreasing the output level by one unit. R&D
investment reduces the marginal production costthrough an increase in the firm's knowledge stock.
The knowledge stock includes technologies andinformation that are useful for reducing themarginal production cost. Since the respective
downstream firms equally trade the intermediate
good with both upstream firms, the same degreeof spillover is assumed to occur from bothdownstream firms to both upstream firms, andthe same degree of spillover is assumed to occur
from both upstream firms to both downstream
firms. Technologies of the rival firm are assumed
to be beneficial knowledge, which is useful foraccumulating knowledge stock, for the respective
firms. This assumes a case in which firms in thesame industry own different expert knowledge.
The knowledge owned by the respective firms
includes information that is required for
efficiently developing and producing theintermediate good and the final good. This
information is useful for R&D conducted by firms
in vertically related industries.

(*1) There is also a contrasting idea that stronger IPR protection increases the degree of R&D spillover. This concept isbased on an assumption that stronger IPR protection will, for example, increase the number of patented, publishedtechnologies, and promote new technology development inspired by those technologies. Indeed, this mechanism isalso important considering the impact of IPRs. However, while stronger IPR protection may increase the number ofpublished technologies, it may not necessarily promote creation of useful technologies (such as basic technologies)that will widely contribute to future technology innovations and increase the number of such patents. Moreover, theanalysis will have to be dynamic (intertemporal analysis) and will involve extremely complicated models, if such amechanism is also taken into consideration. Accordingly, this research will not consider the mechanism in whichstronger IPR protection increases the degree of R&D spillover.
● 155 ●IIP Bulletin 2005

The firms compete in three stages. In thefirst stage, the firms forecast the equilibria of thesecond stage and the third stage, and strategicallydecide the level of R&D expenditure. In thesecond stage, upstream firms compete in the
output level of the intermediate good (Cournot
quantity competition). In the third stage,
downstream firms compete in the output level ofthe final good, similar to the competition in thesecond stage.
Initially, two scenarios are assumed for firm
behavior in the first stage. In the first scenario
the respective firms conduct R&D without
cooperating with the other firms. In this scenario,
firms decide the level of R&D expenditure
non-cooperatively so as to maximize their own
profits. Such a mode of R&D will be called
non-cooperative R&D. For the second scenario
the firms in vertically related industries decide
the level of R&D expenditure in concert. In this
scenario, the downstream firm i and the
upstream firm i(i=1,2) decide the level of R&D
expenditure so as to maximize the joint profits ofboth firms. Since the decisions on R&D are madein concert, this type of cooperative R&D will becalled a vertical R&D cartel.
3

Equilibrium

Section 3 characterizes the equilibrium of
the model introduced in Section 2. The
three-stage game introduced in the previous
section will be solved by backward induction,using subgame perfection as the equilibrium
concept. Specifically, the equilibrium solution ofthis game is obtained by the following method.
First, the equilibrium solution of the third stage(i.e., the optimum output level for thedownstream firm) is obtained with the level of
R&D expenditure chosen in the first stage andthe output level of the intermediate good chosen
in the second stage as given conditions. Then, theequilibrium solution of the second stage (i.e., theoptimum output level for the upstream firm) is
obtained based on the equilibrium of the third
stage. Finally, the equilibrium solution of the firststage (i.e., the optimum R&D expenditure) is
obtained based on the equilibria of the second andthird stages.
After indicating the equilibrium outputs ofthe downstream firms and upstream firms in thesecond and third stages, the requirements met by
the equilibrium R&D expenditure of the firms in
the first stage are shown, both for
non-cooperative R&D and a vertical R&D cartel.
It is also demonstrated that an increase in therespective firms' R&D expenditure will increase
the profits of the vertically related firms.

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4

Comparison of equilibrium results

Section 4 compares the equilibrium results
between non-cooperative R&D and a verticalR&D cartel. As a major result of this comparison,
the section indicates that a firm's knowledge
stock will be larger for a vertical R&D cartel thanfor non-cooperative R&D. In the model used inthis study, a larger knowledge stock reduces the
production cost, so technological improvements
are likely to be promoted in such a case.
The reason that a vertical R&D cartel
achieves higher technological improvement thannon-cooperative R&D can be explained as follows.
The R&D expenditure, which reduces the
production cost for the respective downstream
firms (respective upstream firms), not only
expands the demand (supply) of the intermediate
good, but also reduces the production cost for
both upstream firms (both downstream firms)
through vertical spillover. Therefore, it always
has the effect of increasing profits for both
upstream firms (both downstream firms). When
conducting a vertical R&D cartel, firms spend alarger sum for R&D than when conducting
non-cooperative R&D. As a result, a vertical R&D
cartel has a larger effect of promoting
technological improvement than non-cooperative
R&D.
5

Vertical research joint ventures

Section 5 analyzes vertical research joint
ventures as one mode of vertical cooperative
R&D. Research joint ventures are cooperative
R&D conducted by multiple firms through theestablishment of an independent firm or research
institute. The advantage of research joint
ventures is that firms can avoid redundant R&D.
By participating in a research joint venture, a firm
will be required to provide its knowledge to theother participating firms for free, but it will beable to freely use the knowledge owned by theother participating firms. This study will focus on
this point, and will call the sharing of knowledge
that is useful for R&D among firms in verticallyrelated industries a vertical research joint
venture. A vertical research joint venture will behereinafter referred to as a vertical RJV.
Two vertical RJV scenarios will be assumed
as firm behaviors in the first stage. One is a casewhere a downstream firm i and an upstream firmi (i=1, 2) share all useful knowledge in order toavoid redundant R&D, but do not cooperate indeciding the level of R&D expenditure. Suchcooperative R&D will be called a vertical RJV.
The other is a case where a downstream firm andi an upstream firm i (i=1, 2) share all useful● 156 ●

knowledge as well as cooperate in deciding thelevel of R&D expenditure. Such cooperative R&D
will be called a vertical RJV cartel. The
non-cooperative R&D, vertical R&D cartel,
vertical RJV, and vertical RJV cartel are all modes
of R&D organization that can be adopted between
vertically related firms, so they will becollectively called vertical R&D organizationalmodes in this analysis.
The characteristics of the equilibria areinvestigated for a vertical RJV and a vertical R&D
cartel, and vertical R&D organizational modes arecompared in terms of equilibrium knowledge
stock and equilibrium joint profits. This
comparison gave two results. A vertical RJV and a
vertical RJV cartel increase the firms' knowledge
stock and promote technological improvement. A
vertical RJV cartel achieves the highest
technological improvement and brings about thelargest social welfare among the vertical R&D
organizational modes, but it may not necessarily
produce the largest joint profits that total the
profits of all firms in the two vertically relatedindustries (hereinafter referred to as the ''joint
profits'').
A vertical RJV and a vertical RJV cartel have
two opposite effects on R&D incentives. A
downstream firm (upstream firm) participating incertain vertical RJV or vertical RJV cartel has
stronger incentives for R&D investment, because
it gains useful knowledge from the R&D
counterpart. On the other hand, provision ofknowledge to the R&D counterpart promotes
production of rival firms through an increase insupply (demand) of the intermediate good, so it
weakens the R&D incentives of this downstream
firm (upstream firm). However, since the former
direct, positive effect that vertical knowledge
sharing has on R&D incentives is larger than thelatter indirect, negative effect, a vertical RJV anda vertical RJV cartel promote technologicalimprovement.
There are cases where high R&D incentivesof the firms participating in a vertical R&D cartel
depend on the degree of spillover and are notdesirable from the viewpoint of joint profits andsocial welfare. If expenditure is marginally
increased from the level of R&D expenditure paidby firms in a vertical RJV cartel when the degrees
of horizontal and vertical spillovers are high, it
not only eases the inefficiency of underproduction caused by high market price, but also
the inefficiency of under-investment caused byfree-riding of knowledge. As a result, joint profitsand social welfare will increase. On the other
hand, if expenditure is marginally increased fromthe level of R&D expenditure paid by firms in a

vertical RJV cartel when the degrees of horizontal
and vertical spillovers are low, the inefficiency ofunder-production is alleviated, but there isdeterioration of the unprofitability of overinvestment caused by efforts to win a highmarket share. As a result, joint profits decrease,but since the former easing effect is larger thanthe latter deteriorating effect, social welfare
increases. Therefore, a vertical RJV cartel brings
about the largest social welfare among thevertical R&D organizational modes because it
achieves the highest technological improvement,
but it may not necessarily produce the largest
joint profits.
6

Vertical cooperative R&D and market
concentration

Section 6 investigates the effects of verticalcooperative R&D by generalizing the model totwo vertically related industries where there aren (1 n<∞)symmetric firms in each industry, inorder to investigate the influence of the numberof firms. In economics, a large number of studies
have been made to verify the Schumpeter
hypothesis, which hypothesizes that R&D is more
actively conducted in a more concentrated market(i.e., a market with fewer firms) with regard to
the relationship between market concentration(i.e., the number of firms that exist in a market)－a major indicator for the market structure－and
R&D. The reason for anticipating a positive
correlation between market concentration and
R&D is that a firm that makes higher profits andhas more internal funds is considered to be morecapable of conducting R&D, because it is difficult
to procure outside funds for R&D involving highuncertainties and risks.
It is assumed that n symmetric firms( 1 n<∞) exist in both the downstream industry
and upstream industry. The model is the same as
the basic model in Section 2 except for thenumber of symmetric firms in the respective
industries. Similar to the previous sections, four
scenarios are assumed as firm behaviors in thefirst stage. The first scenario is a case where
R&D is cooperatively conducted. In this case,the respective firms decide the level of R&D
expenditure without cooperating with the otherfirms so as to maximize their own profits. The
second scenario is a case where vertical R&D
cartels are conducted. In this case, the downstream
firm i and the upstream firm i (i=1, … ,n)cooperatively decide the level of R&D expenditureso as to maximize the joint profits of both firms.
The third scenario is a case where vertical RJVs
are conducted. In this case, the downstream firmi and the upstream firm i (i=1,…,n) share usefulknowledge for R&D, but do not cooperate in● 157 ●IIP Bulletin 2005

deciding the level of R&D expenditure. The last
scenario is a case where vertical RJV cartels are
conducted. In this case, the downstream firm iand the upstream firm i (i=1,…,n) share usefulknowledge for R&D as well as cooperatively
decide the level of R&D expenditure. When
conducting vertical R&D cartels, vertical RJVs,
and vertical RJV cartels, the number of verticalcooperative R&D projects will be n.

externalities of technologies within the industry
on potential beneficiaries and imitators.
Therefore, an R&D consortium is often
conducted for basic research or technology
standardization,which
involves
large
externalities. This research assumes a verticalR&D consortium in which not only rival firms inthe same industry, but all firms in two verticallyrelated industries participate.

As a result of analyzing the model ofindustries with n symmetric firms, the following
findings, which differ from those of a model ofindustries with two symmetric firms, were
derived. When there are two symmetric firms in
the respective industries, a vertical RJV cartel
always brings about the largest social welfare
among the vertical R&D organizational modes.
However, if there are three or more symmetricfirms in the respective industries and no spillover
occurs, a vertical RJV cartel may not necessarily
bring about the largest social welfare. The reason
is as follows. If the number of firms in therespective
industries
increases,
marketcompetition will be intensified, so the market
prices will decline and the output levels will
increase. In other words, an increase in thenumber of firms has an effect of easing theinefficiency of under-production. Thus, if
expenditure is marginally increased from thelevel of R&D expenditure paid by firms in a
vertical RJV cartel when there are three or more
firms in the respective industries and no spillover
occurs, it lessens the unprofitability ofover-investment more than it eases theinefficiency of under-production. As a result,social welfare will decrease. Therefore, since a
vertical RJV cartel achieves the largest
technological improvement even when n firms
exist in the respective industries, if three or more
firms exist in the respective industries and no
spillover occurs, a vertical RJV cartel may notnecessarily bring about the largest social welfare
among the vertical R&D organizational modes.

This section uses the model of industries
with n symmetric firms that was used in Section 6.
The following first stage scenario is assumed fora case where a vertical R&D consortium isconducted. All firms in two vertically related firms(i.e., n downstream firms and n upstream firms)
share useful knowledge for R&D andcooperatively decide the level of R&D
expenditure so as to maximize the joint profits ofall firms.

7

Vertical R&D consortium

Section 7 analyzes the vertical R&D
consortium conducted among all firms in two
vertically related industries, and compares it withthe vertical RJV cartel, which promotes
technological improvement the most among thevertical R&D organizational modes. An R&D
consortium is generally cooperative R&D
conducted by the entire industry through theestablishment of a firm or research institute. An
R&D consortium is different from a research joint
venture in that the R&D is conducted by theentire industry. The largest advantage of the
R&D consortium is the ability to internalize the

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This section indicates that, irrespective ofthe degree of spillover, a vertical R&D
consortium
will
promotetechnologicalimprovement more and bring about larger joint
profits and social welfare than a vertical RJV
cartel. When a vertical R&D consortium isconducted, useful information is provided not only
by vertically related firms, but also rival firms, so
firms can accumulate the same level ofknowledge stock at a lower cost than conducting a
vertical RJV cartel. On the other hand, each firm's
R&D expenditure will have an effect of increasing
the profits of rival firms, because useful
information will be provided to rival firms as well.
In a vertical R&D consortium, however, all firms
cooperatively decide the level of R&D
expenditure, so such positive horizontal R&D
externalities can be internalized. Therefore, avertical R&D consortium increases the R&D
expenditure
moreandachieves
highertechnological improvement than conducting a
vertical RJV cartel. The R&D expenditure paid byfirms in a vertical R&D consortium maximizes
the joint profits, since the level of R&D
expenditure is cooperatively decided by all firms.
Therefore, when conducting a vertical R&D
consortium, there is no inefficiency ofunder-investment or over-investment, though
there is inefficiency of under-production.
Accordingly, a vertical R&D consortium brings
about more joint profits and social welfare than avertical RJV cartel, because it promotes
technological improvement more.
8

Discussions

Section 8 presents four conclusions as theimpact of the strength of IPR protection on
vertical cooperative R&D based on the analysis● 158 ●

results in the previous sections. First, verticalcooperative
R&D
promotes
technologicalimprovement irrespective of the validity of IPR
on securing the appropriability of technology.
This is because vertical cooperative R&D
promotes technological improvement better thannon-cooperative R&D, irrespective of the degreeof spillover. When the IPR protection is weak,technological improvement is likely to bepromoted by the R&D promoting effect of thevertical cooperative R&D, and when the IPR
protection is strong, technological improvement
is likely to be promoted even more due to the
R&D promoting effects of the IPR and thevertical cooperative R&D.
Secondly, when IPR protection is strong,
R&D investment in vertical cooperative R&D
may become excessive from the perspective of
joint profits and social welfare. This is because
while a vertical RJV cartel achieves the highest
technological improvement among the verticalR&D organizational modes, R&D investment in a
vertical RJV cartel becomes excessive from theperspective of joint profits if the degree of
spillover is low, and it becomes excessive fromthe perspective of social welfare if there are threeor more firms in the respective industries and no
spillover occurs. When IPR protection becomesstronger, R&D competition becomes intensified
over the appropriability of technology. Moreover,
if the number of firms within the respective
industries increases, firms have a stronger
inducement for R&D in order to capture themarket from rival firms. Because of this, if IPR
protection becomes stronger, R&D investment invertical cooperative R&D may become excessivefrom the perspective of joint profits and social
welfare.
Thirdly, if IPR protection is strong, verticalcooperative R&D may not necessarily increase
joint profits and social welfare. This is
attributable to the second conclusion. In otherwords, if R&D investment in vertical cooperative
R&D becomes excessive from the perspective of
joint profits and social welfare, verticalcooperative R&D may lower joint profits andreduce social welfare due to the inefficiency ofthis over-investment. Therefore, if IPR
protection is strengthened, vertical cooperative
R&D will promote technological improvement,
but it may not bring benefits to firms or society.
Because of this, the benefits of the pro-patent(patent-strengthening) policy would also beaffected by whether or not vertical cooperative
R&D is conducted and the status of market
competition. IPRs do not only induce R&D, butalso affect technology trading and the productmarket, so the IP system needs to be developedin coordination with competition policy andindustrial policy.
Fourthly, a vertical R&D consortium isbeneficial both for the firms and consumers
irrespective of the validity of IPRs on securing
the appropriability of technology. This is becauseaverticalR&D
consortiumpromotes
technological improvement better and brings
about larger joint profits and social welfare thanconducting a vertical RJV cartel, which achieves
the highest technological improvement in thevertical R&D organizational modes, irrespectiveof the degree of spillover. However, one must be
careful about this result. Since rival firms also
participate in a vertical R&D consortium, there isa risk that participating firms may be induced to
free-ride on the technology of other participating
firms without disclosing their own technology, or
incentives for ardent engagement in R&D may be
reduced due to lack of R&D competition. The
analysis results may change if these effects aretaken into consideration.
9

Conclusion

This study theoretically analyzed the impactthat the strength of IPR protection has on verticalcooperative R&D through changes in the degreeof R&D spillover. Three major results wereobtained. Firstly, vertical cooperative R&D
promotes technological improvement irrespectiveof the validity of IPRs on securing theappropriability of technology. Secondly, if IPR
protection is strong, R&D investment in verticalcooperative R&D may become excessive from theperspective of joint profits of all vertically related
firms and social welfare. Thirdly, as a result of
the second result, if IPR protection is strong,vertical cooperative R&D promotes technologicalimprovement, but it may not necessarily increase
the joint profits of all vertically related firms andsocial welfare.
The results of this research indicate that, if
IPR protection is strengthened, verticalcooperative R&D will promote technologicalimprovement, but it may not necessarily bring
benefits to the firms or society. Thus, thebenefits of the pro-patent (patent-strengthening)
policy will also be affected by whether or notvertical cooperative R&D is conducted and thestatus of market competition. In addition, since
IPRs not only induce R&D, but also affecttechnological trading and the product market, theIP system needs to be developed in coordination
with competition policy and industrial policy.
The above conclusion may rely on thefollowing four points. The first point is that the● 159 ●IIP Bulletin 2005

size of the final good market and the intermediate
good market as well as the productivity of R&D(the R&D capacity of a firm) were considered as
exogenous variables (given conditions) in theanalysis models. These factors affect theefficiency of a firm's production and R&D. The
second point is that the analysis models assumed
that the firms of the respective industries
competed not in price but in output level. This
point should be noted, because price competition
often derives results that are essentially different
from production competition. The third point isthat this research did not address the issue of
whether or not firms will conduct verticalcooperative R&D. It would be necessary toconsider the issue of profit distributions between
the downstream firm and the upstream firm when
conducting vertical cooperative R&D. The fourth
point is that, while firms may license theirtechnology to other firms, the analysis models did
not take firms' licensing activities into
consideration. Analysis of these factors will beconsidered in future research.

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