Intellectual Property Rights, FDI, and Technological Development

Xianzhong Yi

Alireza Naghavi

Nanjing Audit University

University of Bologna

Abstract
This paper presents the double trade-off faced by a lagging country in strengthening its
intellectual property rights (IPR) regime between (i) attracting FDI and deterringinternational technology spillovers, (ii) encouraging domestic innovation and suppressing
technology diffusion. The optimal level of IPR protection depends on the technologicalcapability of the host country. In less-developed countries IPRs should be just strong
enough to induce FDI. Stronger protection is recommended for more advanced countries as
IPRs encourage their domestic innovators. The results cast doubt on the adequacy of
globally harmonized IPR standards that do not consider the level of development.
Keywords

IPR Protection; Technological Capability; Domestic Innovation; FDI

JEL classification

F23; O33; O32

Acknowledgment We are grateful to Xiaolan Fu, Giacomo Zanello, and seminar participants at theTechnology & Management for Development Centre and Saï
d Business School Joint Workshop,
Oxford University for their comments and suggestions. Financial support of China National Social
Science Foundation（NO.11BJL053）and the Open Fund Project of Key Research Institute ofPhilosophies and Social Sciences in Hunan Universities (NO.12IEPMZ1) are gratefully
acknowledged.
X. Yi
Economic and Trade school, Nanjing Audit University,
86 Yushan West Avenue, Nanjing 211815, China.
E-mail: yixianzhong007@163.com.
A. Naghavi
University of Bologna, Department of Economics, Piazza Scaravilli 2, Bologna 40126, Italy.
E-mail: alireza.naghavi@unibo.it.

1 Introduction
The TRIPS (Trade Related Aspects of Intellectual Property Rights) agreement has led to a
global trend toward stronger intellectual property rights (IPR) protection over the past
decades. This initiative has been most drastic for developing countries (South), which wererequired to upgrade their IPR standards to those in force in the developed world (North).
This was clearly seen as a severe and costly adjustment by the South, making the latter
reluctant to comply with the guidelines (Ghio, 2011). The concerns led to the transitionalarrangements in Article 65 of the TRIPS agreement that granted the least developed
countries a longer time-frame to implement the TRIPS provisions. To avoid pushing theSouth towards technological isolation, the following Article 66 of TRIPS further obliged
the North to promote and encourage technology transfer by its firms as a form ofcompensation in order to substitute imitation with more legitimate means of creating aviable technological base in the South. Foreign direct investment (FDI) has often beenreferred to as an important source of such technology transfer, due to its role as a catalyst
for industrial development, see for instance Markusen and Venabales (1999). A plausible
motive for the South to strengthen IPR protection is therefore to attract FDI and thereby
facilitate technology spillovers. But is the attraction of FDI under a strong IPR environment
necessarily accompanied with the envisioned technology transfer and development?
The aim of this paper is to determine circumstances under which FDI-inducing IPR
protection also brings benefits to the South. In the spirit of Hall (2013) we split the problem
and study (i) when IPR protection results in inward technology transfer by attracting FDI,
and (ii) whether this hinders or spurs technological development through domestic
imitation and/or innovation. Vast theoretical and empirical evidence points to the positiverole of IPR in promoting technology transfer by inducing FDI.1 Nevertheless, the responseto the second question is not straight forward. In particular, our study is inspired by recent
empirical findings of Kashcheeva (2013), who finds that regardless of the positive effectsof FDI and IPRs, stronger IPRs weaken the growth effect of FDI for developing countries.
While IPR protection may attract new technology, it does not necessarily result in its
diffusion in the domestic economy. IPR protection may for instance hamper the diffusion of
FDI-driven technology made possible by imitation defeating the very purpose for its
adoption. In addition, recent theoretical works such as Mathew and Mukherjee (2014),
Mukherjee and Sinha (2013) and Poyago-Theotoky and Teerasuwannajak (2013) haveestablished the growing importance of southern innovation when studying issues related totechnology diffusion. It is therefore essential to also bear in mind the trade-off between
suppressing international technology diffusion and promoting domestic innovation in alagging country. Technology transfer through FDI, technology diffusion through imitation,and domestic innovation are three interrelated dimensions on which IPR protection exerts
conflicting effects. It is therefore necessary to view the problem from a broader perspective.
Namely, the technological gap, innovation efficiency and absorptive capacity in the South
1

Gaining technology spillovers are a main reason why developing countries are interested in attracting FDI.
Developing countries can benefit technologically from strengthening IPRs by attracting FDI, see for instanceLai (1998), Maskus (1998), Javorcik (2004), Branstetter et al. (2006), Iwaisako et al. (2011), Mondal andRanjan Gupta (2009), Gustafsson and Segerstrom (2011) and Branstetter and Saggi (2011).
1and the spillover propensity in the industry prove to be some of the key variables that
determine the extent to which the intended benefits from IPRs can be fulfilled.
This paper provides a framework to examine the double impasse between (i) attracting
FDI and deterring international technology spillovers and (ii) encouraging domestic
innovation and suppressing domestic technology diffusion, to address conditions underwhich a developing country seeking to attract FDI can in fact benefit from adopting
stronger IPR protection. The analysis starts by showing that IPR protection can be used to
attract FDI by reducing the degree of technology spillovers that can be legally used by hostfirms. The findings cast doubt on the idea that IPRs always benefit the South in terms oftechnological attainment. Whether or not IPR protection can be welfare enhancing depends
on the technological capability of the host country in terms of the distance to thetechnology frontier and domestic innovation efficiency. When the technological capability
is weak reflecting inefficient innovation in the domestic industry, IPR protection should notexceed the minimum level that can attract FDI. The analysis also shows that althoughstricter levels of IPR protection can induce FDI in more industries, it unfavorably leads to atransfer of welfare from South to North in industries where FDI is already present. For
more advanced countries in the South where the technology gap is small or a higher level ofinnovation efficiency has been reached, a optimal IPR regime is stronger than the level thatinduces FDI. IPRs here also play an important role in protecting domestic innovation andspur technological development. We can conclude that IPR protection in the South shouldbe left to the minimum necessary to attract FDI in the first stages of development, andenhanced to a stronger level once the preconditions for technological development are met.
A series of previous works confirm that strengthening IPR enforcement can attract
superior technology in R&D intensive industries (Lee and Mansfield, 1996) or more
technology-intensive sectors (Javorcik, 2004) through higher quality FDI (Nunnenkamp
and Spatz, 2004) to countries with stronger imitative capacity (Smith, 2001). Yet, it is also
true that the role of IPR protection as safeguard against technology spillovers creates apolicy dilemma when it comes to exploiting the technology brought in by FDI.2 On the one
hand, a lagging country should strengthen its IPR regime to attract FDI consisting ofsuperior technology. On the other hand, stronger IPR protection reduces the legal ability offirms in the host country to benefit from technology spillovers. Assessing this trade-off,
Glass (2005) and Naghavi (2007) showed that the IPR protection in a lagging country
should be just strong enough to attract FDI.
The dominant theoretical literature on IPRs and FDI typically divides the world into
an industrialized innovating North and a less developed imitating South, neglecting theimpact of IPRs on potential domestic innovation. While the role of imitation at the lower
stages of development is indispensable, countries at a relatively more advance position tend
to be more willing to adopt IPRs to protect their own inventors. Chen and Puttitanun (2005)
developed a model to illustrate the trade-off between imitating foreign technologies and2

The predominant point of view derived from the North-South technology transfer framework states thatstrengthening the protection of IPRs in the South would undermine overall welfare and inhibit technologicalprogress (Helpman, 1993 ；Glass and Saggi, 2002), block the free flow of scientific knowledge frominnovations (Gangopadhyaya and Mondal, 2012), or work against national economic interests by transferring
rents to multinational corporate patent holders headquartered in the North (McCalman, 2001; Adams, 2008).
2

encouraging domestic innovation in a developing country’s choice of IPRs, and found thata country's optimal level of IPRs depends on its level of development non-monotonically,first decreasing and then increasing. The existence of an empirical U-shaped curve between
IPRs and per capita GNP has also been noticed empirically by Maskus (2000) and by Braga
et al., (2000). Glass (2010) and Lorenczik and Newiak (2012) specifically consider theimitation of Southern innovation to investigate whether stronger IPR protection promote or
discourage further innovations that build on existing ideas. Glass (2010) emphasizes theimportance of imitation in providing the South a sufficient knowledge base as a steppingstone to innovation, whereas Lorenczik and Newiak (2012) highlights the role of IPRs ingenerating a shift from an imitating to an innovating South.3 The model presented in thispaper essentially incorporates the idea of domestic innovation and imitation introduced in
Glass (2010) and Lorenczik and Newiak (2012) into the basic trade-off between FDI andtechnology spillovers assessed in Glass (2005) and Naghavi (2007).
The rest of the paper is organized as follows. The next section presents a basic
framework. Section 3 illustrates the inflow of FDI, and section 4 investigates the optimallevel of IPR protection to attract FDI in the context of one industry. Section 5 verifies theeffects of IPRs under multiple industries. Concluding remarks are contained in section 6.
2 Basic Models
Consider a world economy that consists of two regions: a technologically advanced
North and a lagging South. A northern source firm (s) engages in innovation and enjoys full
IPR protection at home. Host firms in the South (h) also engage in innovation, but animperfect IPR regime allows them to imitate the northern firms and other southern firms.
Suppose a simple game that takes place in two stages. In the first stage the government in
the South sets the IPR protection level and the source firm with superior technology decides
whether to export or to move production to the South. In the second stage, the source firm
and the host firms produce a homogeneous good and engage in Cournot competition. Inline with Leahy and Naghavi (2010), in our basic framework we consider two host firmsthat are symmetric in terms of technology and average cost.4
Let the output of firm i be given by qi , where i {1, 2, s} represents the two host firms
and the source firm respectively. Total output is given by Q  qh  qs  q1  q2  qs . The
demand function is linear for computational ease： p(Q)  a  Q . Firm i chooses its quantity

qi to maximize profits,  i  [ p(Q)  Ci ]qi ，where Ci represents the average cost of eachfirm. The equilibrium output of each firm is derived from the standard first-ordercondition,  i / qi  0 and solves:qs a  2Ch  3Cs
a  Cs  2Ch
and q1  q2 
4
4

(1)

This yields profits of:3

Leahy and Naghavi (2010) and Lorenczik (2012) extend the argument in another dimension and instead lookat the interaction between the IPRs and the FDI policies on technology transfer and Southern welfare in thepresence of joint ventures and domestic innovation respectively.
4
The scenarios of multiple host firms and multiple industries will be addressed in the upcoming sections.
3

s 

(a  2Ch  3Cs ) 2and16

1   2 (a  Cs  2Ch )216(2)

Suppose the average cost depends on the level of technology, and that the source firmholds technological advantage over the two host firms. Let AS represent the technologicallevel of the source firm and Ai (i=1, 2) that of domestic firms. To produce one unit ofA
output, the source firm needs one unit of labor, whereas the host firms need  ( = S  1 )Aiunits of labor. Parameter  in other words represents the technological gap between thetwo regions. The wage in the host country is normalized to one. The average cost of
production for the source firm is equal to one if it produces in the host country, but  > 1 if
it chooses to produce at home and export, due to higher wages or trade costs. Accordingly,
the host country offers potential cost savings to the source firm, but at the expense of
risking technology spillovers to rival firms.
Technological progress in terms of reducing the costs of production takes place
according to A, where A is the stock of knowledge capital, and  represents theefficiency of domestic innovation. Knowledge capital (A) consists of the old technology,
which has been imitated by other R&D enterprises, and new technology not yet replicated.
There is the implicit assumption that these two types of technology have the same functionin technological progress. It is however more plausible to think of newer technologies being
more relevant than vintage knowledge in the evolution of technological capabilities, whichis also the essence of Schumpeter's theory of creative destruction. Mondal and Gupta (2006)
for instance develop a framework where knowledge capital solely includes the novel
technologies. Following this approach, our model assumes that old imitated technology isineffective for R&D, whereas new technologies are the key contributors to innovation.
Define the degree of IPR protection as  , where 0    1 . If   0 , all newtechnologies can be imitated due to the lack of an adequate IPR regime. Alternatively
if   1 , new technologies cannot leak due to the perfect enforcement of IPRs. Thus, 1  
represents the fraction of new technologies, which are subject to imitation based on the hostcountry’s IPR protection level. Let the degree of practical technology spillovers in theindustry be , whereas only a fraction  can be absorbed by host country firms.
Absorption capability  may implicitly be a function of the imitation capacity of hostfirms, the education and experience level of the workforce or other host country factors.
K   (1   ) is therefore the total fraction of new technology that can be imitated.
According to the definition above, the knowledge capital of host firms is derived fromthe expression Ai  KAi . Domestic innovation of host firms evolves as:

iin   [ Ai  KAi ], i  1,2(3)

Note that a host firm only imitates the new technology of the other domestic firm
because the vintage technologies have no effect on the development of new inventions.
Technology available to one host firm through the imitation of another domestic firm is:iimh  Kiin  K[ Ai  KAi ], i  1,2(4)

Equation (4) simply captures the feature that ideas build on other ideas, as pointed out in
Boldrin and Levine (2004). The third channel of technological progress for domestic firms
4

is to imitate the superior technology of the source firm. The fraction of imitable technology
is As  Ai . Thus, the technology available to each domestic firm through the imitation of
the source firm is:iims  K ( As  Ai ), i  1,2(5)Technology spillovers are assumed to be larger under FDI than exports:  F   X .
Hereafter we distinguish spillovers under the two modes by referring to it as   F   X ，where  1 .
Aggregating the three sources of progress, the total new technology of each host firm
can be written as：

i  iin  iimh  iims , i  1,2(6)

Suppose the new cost-reducing technology influences production in the same way
regardless of whether it is obtained from domestic innovation or imitation. That is, one unitof labor is required to produce one unit of output either by innovating the technology orimitating it. The proportion of new and old technologies are i / Ai and 1  (i / Ai ) ,respectively. Hence, the average cost to each host firm is：

Ch  (i / Ai ) 1  (1  i / Ai )  (7)

Substituting Equations (3), (4), and (5) into (7), the average costs of each host firm under
FDI (F) and exports (X) are:

ChF  [ (1  K 2 )  K (  1)](1  )  (8)ChX  [ (1  K 2 )  K (  1) / ](1  )  (9)Combining Equations (2) and (9) we obtain profits under exports：sX (a  2Ch X  3 )216

and  1 X   2 X (a    2Ch X ) 2
16

(10)

Equations (2) and (8) in turn derive the profits under FDI:

 a  2C  3
 
F
s

F
h

16

2

and  1   2
FF(a  1  2Ch F ) 2

16

(11)

3 IPR protection and FDI
In line with Ferrantino (1993), the source firm chooses between FDI and export as its
mode of serving the South given the host country’s level of IPR protection, acknowledging
that FDI makes it more likely for its superior technology to be disclosed to host rivals.
Keeping production in the North helps safeguard its technology due to physical distanceand the lack of a demonstration effect, but entails higher marginal costs of production(>1).
The minimum level of IPR protection required by the source firm to select FDI is5determined by setting profits under the two modes equal,  sF (1, Ch F ) ＝  sX ( , Ch X ) , toobtain(a  2Ch F  3)2 (a  2Ch X  3 )2

16
16

(12)

Substituting Equations (8) and (9) into (12), the minimum IPR level necessary to attract
FDI is:3(  1)(13)
s  1 
2 (1  1  )(  1)2
We can also examine how various parameters of the model affect this threshold. Simple
comparative statics reveal  s  0 ，  s  0 ,  s  0 . A larger technology gap (Γ) impliesthat the source firm incurs larger losses upon the imitation of its technology therefore
requires tighter IPR protection to undertake FDI.5 At the same time, a higher absorptive
capacity in the host country (  ) also deters FDI in the absence of a sufficiently strong IPR
regime. The degree to which an industry is predisposed to technology spillovers (  ) also
affects the critical level of IPRs that induces FDI positively as losses from spillovers larger
under FDI than exports.
Allowing for n identical host firms, the IPR threshold becomess  1 n(  1) (n  1)(1  1  )(  1)2(14)

A larger number of host rivals will amplify the damage to source firm’s profits fromtechnology spillovers: s n  0 . Therefore, the larger the number of host rivals, thetighter IPR protection is required for FDI to occur. Seen the other way around, given the
IPR level the source firm tends to choose FDI over exports in less competitive industries toprevent severe technology spillovers.
The analysis so far shows that IPR enforcement can succeed in attracting FDI. We now
turn to the welfare implications of IPRs to see whether they can prove beneficial to thedeveloping world. Observing first the consumer surplus, CSh j  (a  P j )Q j / 2 , it is easy
to see that consumers are always better off with FDI than under exports:(3a  2Ch F  1) 2
(3a  2Ch X   ) 2. This arises due to lower production
CSh F  CSh X 
32

32

costs, and hence higher output and lower prices in equilibrium under FDI. We next evaluate
total welfare in the lagging country to determine the optimal level of IPR protection undereach mode. Define welfare in the lagging country as the sum of profits and consumer
surplus. The optimal level of IPR protection is obtained by:m a xWh J  2 hJ  C Sh J J ,  X, F .
As per Wh F /   0 and  2Wh F /  2   0 , the optimal IPR protection of the lagging
country under FDI is
5

It will be shown in section 5 that if the technology gap is viewed from an industry (instead of country)
perspective as suggested by Glass (2005), FDI occurs first in industries with the smallest technology gap that
confer the smallest gains to the host country. The policy of strengthening IPRs to attract FDI and benefit fromtechnology spillovers may therefore prove ineffective.
6 F*  1  12  

(15)

Equation (15) suggests an inverted U-shaped relationship between IPRs and welfare in theSouth under FDI as Wh F /   0 for    F * , whereas Wh F /   0 for    F * .
The optimal IPR regime under exports can be obtained in a similar manner and is X*  1

Wh F

   1 

(16)

2

Wh X

Wh
Benefitfrom
FDI but harm
FDI

Export
Fig. 1

F

s





X

IPRs and Welfare under FDI versus Export

Comparing Equations (15) and (16) yields  X *   F * . That is, the optimal level of IPR
protection is stronger under exports than FDI. This is because lower spillovers underexports reinforce the importance of domestic inventions and the need for their protection tofoster technological progress. In fact, the inverted U-shaped relationship between IPRs andwelfare comes from the double-edge effect of strengthening IPR protection ontechnological progress, thereby on the cost and eventually on the profits of host firms andconsumer surplus in equilibrium. We show in Appendix 1 that the profits，consumer surplus
and therefore welfare in the lagging country all move in the same direction with IPR
enforcement. Strengthening IPR protection can encourage FDI and domestic innovation,
but deters international and domestic technology diffusion. Strengthening IPR protection
has a non-monotonic effect on welfare, implying that FDI does not always lead to a higher
welfare than exports. In particular, when IPR protection is strong, southern welfare under
FDI can be inferior to that under exports. Figure 1 depicts welfare for each equilibrium
supply mode under different levels of IPR protection.
Proposition 1. The relationship between IPR protection and welfare in the lagging country
takes an inverted-U shape. Stronger IPR protection can enhance welfare by attracting FDI
and encouraging domestic innovation, but also causes a deterioration of welfare byblocking international and domestic technology diffusion.
4 Technological Capability and the Optimal IPR Regime
This section investigates the main factors determining the optimal level of IPR
protection for the South in the context of one single industry and whether it induces FDI.
Equation (15) in the previous section illustrates how the optimal level of IPR protection in7

the South under FDI depends on technological capability. Stronger technological capability,that is a narrower technology gap  or higher southern innovation efficiency  , brings
the need for a stricter IPR regime as  F * /   0 , and  F * /   0 . According to s F /   0 and  2 s F /  2   0 , the level of IPR protection that maximizes the host’s
welfare with FDI is identical to the level that generates the minimum profits for the source
firm under FDI (  sF * ):

sF *   F *  1 

 1
2

(17)

Equation (17) suggests a U-shaped relationship between IPRs and the profits of the source
firm under FDI as  s F /   0 for   s F * , whereas  s F /   0 for   s F * .
When    F * , strengthening IPRs will increase the welfare in the host country( Wh F /   0 ) and decrease the profits of the source firm (  s F /   0 ) because thefull capacity of domestic innovation is not realized under a weak IPR regime. In addition,
the positive effect of stronger IPRs on domestic innovation outweighs its negative impact
on imitation. Thus, strengthening IPRs reduces costs of host firms, making them morecompetitive against the source firm, and increases the host consumer surplus through lower
prices and higher output in equilibrium. We show in Appendix 2 how the price and total
output in equilibrium change in IPR enforcement. When    F * instead, strengthening
IPRs will decrease the host welfare and increase the profits of the source firm as thecapacity of domestic innovation is already exhausted with strict IPRs and the positive effectof stronger IPRs on domestic innovation falls short of its negative impact on imitation.
Thus, strengthening IPRs further increases costs of host firms and decreases the hostconsumer surplus in equilibrium, and leads to a transfer of welfare from the host firms andconsumers to the source rival in equilibrium.
Likewise, when the source firm opts for exports the optimal IPR protection for theSouth is equal to the level that minimizes the profits of the source firm (  sX * ):sX *   X *  1    1 

(18)

2

Equation (18) also suggests a U-shaped relationship between IPRs and the profits of thesource firm under export. Recalling  X *   F * , the curves Wh F and  s F lie to the left of

Wh X and  s X . Technology gap and domestic innovation efficiency turn out to play animportant role in determining the optimal IPR level and the supply mode. For relatively low
technologicalcapability,

i.e.

when

  3 3(  1) 1  1/   1or(and)      1 1  1/  / 3(  1) , inequality s   F * holds. In this case, the first-best
IPR regime is not sufficiently strong to attract FDI. Figure 2 illustrates this relationshipbetween Wh X ,  s X , Wh F and  s F .Figure 2 shows that when IPR protection in the lagging
3

country is weak (   s ),  s X   s F holds indicating that the source firm chooses toexport to reduce technology spillovers. Under exports, strengthening IPRs lowers profits ofthe source firm (  s X /   0 ), while increasing that of the host firms (  h X /   0 )by encouraging domestic innovation. Moreover, minor spillovers with exports gives more8

weight to the impact of IPRs on domestic innovation relative to its adverse effects ofinhibiting the diffusion of domestic and foreign technologies. In addition, consumers’
surplus under exports is also an increasing function of IPRs, that is CSh X   0 , asshown in Appendix 1. All in all, when   s so that the source firm prefers to export,
strengthening IPR protection shifts profits from the source firm to southern consumers andXfirms, resulting in the increment of the welfare in the lagging country( Wh ). When IPR
protection level reaches  S and the source firm switches mode to FDI, there is a jump insouthern welfare. However once FDI is the established supply mode due to sufficient IPRs
(   S   s F   s X ), further tightening of the IPR regime has the opposite
consequences:  s F /   0 ,  h F /   0 and CSh F   0 . Strengthening IPR
F

protection decreases the welfare in the lagging country ( Wh ) in terms of consumer surplus
and the profits of the host firms, while increasing the profits of the source firm. This isequivalent to an international transfer of welfare from the host country to the foreign firm.
This conclusion is consistent with McCalman’s (2002) empirical results, which argue that
increasing IPR protection in the South to the level in force in the North results in a large
volume of income transfers from developing to advanced nations. The results under low
technological capability support Glass (2005) and Naghavi (2007) in that IPR protection
should only be strong enough to bring in FDI.

 s , Wh

 sF

 sX

 sF
 sX

Wh F

Wh

Wh X

X

Wh F



F* 

s





X*

Fig. 2 The optimal IPRs Protection when s   F *Proposition 2. The optimal IPR protection to attract FDI depends on domestic
technological capability in terms of technology gap and innovation efficiency. When  3 3(  1) 1  1/   1 or (and)      1 1  1/  / 3(  1) , s   F * holds.
3

Since Wh F  s Wh X  s, the optimal IPR protection for the lagging country is the level

just sufficient to attract FDI (  S ).
When the South enjoys a relatively high level of technological capability so that  3(  1) 1  1/    1 or
3(and)      1 1  1/  / 3(  1)
3,

inequalitys  s F * holds implying that the optimal IPR protection in view of the South is enough9

to attract FDI. Figure 3 shows the relationship between Wh X ,  s X , Wh F and  s F . Startingfrom weak IPR protection (   S ),  s X   s F indicates that the source firm chooses
export over FDI. Moreover,  h X /   0,  s X /   0 , and CSh X   0 specify
that welfare in the lagging country ( Wh X ) is increasing, while the profits of the source firm
is decreasing in IPR enforcement. When S     F * , the source firm opts for FDI
as  s F   s X , where  h F /   0,  s F /   0 ， and CSh F   0 point towards
the role of IPRs in transferring income from source to host firms and domestic consumers.
A stricter IPR regime than the FDI-inducing level is here beneficial to the South. Finally,
very high levels of IPR protection (    F * ) results in a transfer of welfare from the hostcountry to the foreign firm. This allows us to conclude that in countries that have reachedhigher levels of technological capability, welfare in the lagging country is at its maximum
level when    F * . This is contrast with Glass (2005) and Naghavi (2007), highlighting
the positive role of IPR protection for technological progress in countries at a higher stageof development. The significance of IPR protection here goes beyond the attraction of FDI
due to an existing domestic innovation sector.

 s , Wh

s

X

s

F

s

F

s

X

Wh F

Wh X

Wh F

Wh X

s  F*



X*

Fig. 3 The optimal IPRs Protection when s   F *Proposition 3. When domestic technological capability is strong enough, i.e.
  3 3(  1) 1  1/    1 or (and)      1 1  1/  / 3(  1) , s  s F * holds.
3

The optimal IPR protection of the lagging country is therefore  F * and lies above the
FDI-inducing level to support domestic innovation in countries that have reached asufficiently advanced stage of development.

5 Heterogeneous Industries
In this section we view the main determinants of the optimal IPR regime in the South,
namely technology gap and innovation efficiency, from a heterogeneous industries
10perspective. This changes the argument in the sense that the optimal level of IPR protection
and/or the level required to attract FDI differs according to the technological capability inthe industry (as opposed to the whole country).
Putting the results obtained in the previous section in the context of heterogeneous
industries, industries with smaller technology gaps and stronger innovative efficiency
require stronger IPR protection. This implies that tighter IPR enforcement initially attracts
FDI in industries with minimal gains for the host country. Strengthening IPRs further
attracts FDI in more industries, but at the expense of excessive IPR protection in industries
with existing FDI. Recalling the uniform character of IPR across all industries, IPR
protection can after a certain point become harmful to the South.
Suppose for example n industries with increased technological capability overindustries, where S   F * for simplicity as the argument holds for both first-best
optimal IPRs and the FDI-inducing level. We know from the previous section that  F 
increasing in the technological capability, now of an industry. Let the total profits of firms
in each industry be  i . The optimal level of IPR protection for the least efficient industryis 1F  . When IPRs are strengthened to 2F  , the profits of the second (more efficient)industry reach a maximum, while the profits in the first industry are reduced. Similarly,
Strengthening IPRs protection to 3F  will raise host profits in the third industry and reduce
profits in the first two industries, and so forth. More generally, when IPR protection isstrengthened from nF1 to nF  , profits in the nth industry reach their maximum level but
reduced in the n-1 industries. This causes a reduction of overall host profits if the following
condition is satisfied:n 1 (  )   (  )    nF (  )   nX (  )

i 1
F
i

F

n1

F
i

F
n

F
n

F
n 1

(19)

The greater the number of industries, the more likely it is that the increased costs for hostfirms in other industries outweighs the benefits from lower costs in the industry thatswitched to FDI.6 It is therefore important to remember that although policymakers areconstrained to implement a uniform IPR regime across all industries, the optimal protectionlevel needed to attract FDI varies by industries. Chu (2011) suggests that in this case thelevel of IPR protection should be set as a weighted average of its sector-specific optimalvalues.
6. Concluding remarks
An argument generally used to support the strengthening of IPRs protection in lagging
countries is that doing so will attract FDI and result in a welfare gain through technology
spillovers. In this paper, we re-examine the argument in a two-stage game by focusing on
its double trade-offs: the simultaneous need for attracting FDI, facilitating international
technology spillovers, providing incentives for domestic innovation, and stimulating
domestic technology diffusion. Our study finds that optimal IPR protection varies
according to technological capability in terms of technology gap, and research efficiency of
6

As shows in Appendix 1 that consumer surplus moves the same direction as the profits in the lagging country,
so the idea can be extended to welfare.
11

domestic innovation. Stringent IPR protection above an optimal level induces a welfaretransfer from home to abroad. More precisely, for less technologically developed countries,
IPR enforcement should just be enough to attract FDI, whereas a stronger protection levelis optimal for more advanced countries with an active and efficient domestic innovation
sector.
Our analysis suggests that attracting FDI can indeed be beneficial to lagging countries
and that IPRs can be an instrument to encourage it. We show however that IPR protection isa delicate policy, and that the global harmonization of IPRs can hardly serve well the
purpose of welfare maximization. This conclusion is in contrast with some recent welfare
analyses of IPRs like Iwaisako et al., (2011), who conclude that stricter forms of IPR
protection in the South are always welfare maximizing for both the North and the South.
The crucial dilemma for the practice of IPRs is that the optimal level of IPR protection
varies across countries (and even by industry) according to technology gap and innovation
efficiency. The results are in line with Schumpeterian growth model of Chu, et al. (2014) inshowing that the optimal degree of IPR protection depends on the stage of development.
This implication provides another reason as to why the harmonization of global IPR
protection may not be beneficiary to developing countries given that the industrial
technological capability differs significantly across some countries. Also, the dilemma of
the double trade-off presented is especially relevant for some large emerging economies
with massive industries like China, Russia and India, where some industries have achieveda remarkable catching-up while others still overly depend on technological adoption.
Therefore, our analysis suggests special attention should be given to the heterogeneity
across countries and industries in the practice of IPR protection. In the long-run, aiding
lagging countries directly to increase their innovative capabilities and close the technology
gap is perhaps the best initial step in promote the harmonization of global IPR protection.

12

Appendix 1
Take example of welfare analysis under FDI. Let the price and overall output in equilibrium under
FDI are p and Q

FFWh  2  CSh

F

F

F
h

respectively.

p F Q F 2  a  1  2Ch
 2 

2
16
F
h

F

   3a  2C  1
2

F
h

2

32

Wh F
 F CSh F
Ch F 1
Ch F
1
2 h    a  1  2Ch F   3a  2Ch F  1
u
u
u
2
u
8
u
And

 2Wh F1
1
   a  1  2Ch F    3a  2Ch F  1  0
2
u
2
8

Where a  1  2Ch

F

 q F h  0 and 3a  2Ch F  1  Q F  0

Wh F
 hF
CSh F
Ch F)  sign()  sign()   sign()
So sign(
u
u
u
u
When   while   

 1

F*

F*

,

 hF
CSh F
W F
  1 Ch F,
 0 and 0,
 0, h  0 ,uuu2 u

Ch F
 hF
CSh F
W F
 0 and 0,
 0, h  0
u
u
u
u

Welfare analysis under export can be obtained in a similar way.

Appendix 2
The overall output in equilibrium under FDI Q
under FDI p

F

When    2a  2Ch F  1 . So sign(

F*

,

F

 3a  2Ch F  1 , and the price in equilibrium

C F
Q F
p F
)  sign( )  sign( h ) .
u
u
u

Ch F
C F
Q F
p F
 0 and 0,
 0 ,while    F * , h  0 and
u
u
u
u

Q F
p F
 0,
 0.
u
u

13

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