Discussion Paper Series No.195
Globalization, R&D and Endogenous Choice of Technology

Fuat SENER
Laixun ZHAO
November

Union College
Kobe University
2006

The Discussion Papers are a series of research papers in their draft
form, circulated to encourage discussion and comment. Citation anduse of such a paper should take account of its provisional character.
In some cases, a written consent of the author may be required.

Globalization, R&D and Endogenous Choice of Technology

Fuat Sener a

Laixun Zhao b

Union College

Kobe University

Abstract
This paper constructs a dynamic scale-free North-South model of trade with endogenous innovation. In
the North two types of R&D races take place simultaneously within each industry. One is local-sourcingtargeted R&D race, which results in the winner firm manufacturing in the North. The other is
outsourcing-targeted R&D race, which culminates in the winner firm manufacturing in the South. In
equilibrium, manufacturing costs are lower in the South, but engaging in outsourcing-directed R&D ismore costly than local-sourcing directed R&D. Entrepreneurs optimally choose the degree of challenges
associated with their R&D projects and thereby determine their ex-post manufacturing productivity levels.
More challenging R&D projects require more resources ex-ante but generate more labor saving in
manufacturing ex-post.
We study the effects of globalization by considering a reduction in the resource-requirement inoutsourcing-targeted R&D (triggered by reduced communication and transportation costs). Such a change
reduces the North-South wage gap and increases the mass of outsourcing industries. The aggregate
innovation rate increases despite the possibility of a fall in the rate of local-sourcing directed R&D. We
also investigate the effects of Southern policies towards FDI. We find that subsidies that reduce the costof multinational manufacturing in the South may have an adverse effect by reducing the measure of
Outsourcing industries. On the other hand subsidies that facilitate the technology transfer efforts ofNorthern firms unambiguously increase this measure. An increase in either type of subsidy raises theaggregate innovation rate and diminishes the North-South wage gap.
Keywords: Outsourcing, Foreign Direct Investment, innovation, product cycle, endogenous growth
JEL Classification: F12, F23, O14__________________
a: Department of Economics, Union College, Schenectady, New York, 12308 USA, senerm@union.edu;
b: Corresponding Author: Research Institute of Economics & Business, Kobe University, Kobe 6578501, JAPAN, zhao@rieb.kobe-u.ac.jp, Fax: 81-78-803-7059.

1

1. Introduction
Developing countries are taking over as the most attractive destinations for Foreign Direct Investment(FDI) in recent years. In 2003, China, the U.S. and India ranked 1st, 2nd, and 3rd as the destinations that
attracted the largest amounts of FDI. In a recent UNCTAD survey, both FDI experts and executives ofmultinational corporations answer that the five most attractive business locations globally for the years
2005-2006 are in the following order: China, USA, India, Russia and Brazil (See UNCTAD/PRESS/PR/
2005/031/05/09/05). The recent surge of FDI to the developing countries stemmed from a host of factors,
including especially technology improvements which lead to reductions in transport and communication
costs, developing-country policies that attract FDI including subsidies, tax holidays, etc., and theemergence of bilateral/multilateral investment treaties.
In the traditional product cycle model as proposed by Vernon (1966) multinational firms serve as
the main channel of North-South technology transfer. Entrepreneur firms participate in R&D races toinnovate new products. The winner of each race gains access to technology of producing the nextgeneration product and starts the manufacturing process immediately in the North. By keeping production
in close proximity to R&D workers, the successful innovator can efficiently monitor the production
process and make the necessary modifications if needed. Over time as production becomes standardized,
firms look for ways of shifting production to the South to exploit low-cost manufacturing opportunities.
Success in technology transfer implies the shifting of manufacturing to the South. This cycle is reignitedwhen further innovation in the North renders obsolete the products manufactured in the South.
Increasingly though this type of product-cycle framework is facing a serious threat of creative
destruction. With the decline in transportation, communication and trade costs, we have witnessed in thepast two decades the emergence of globally-integrated production networks through which Northern
innovators can bypass the Northern standardization stage and shift manufacturing to the South
immediately after innovation success. This essentially implies that Northern entrepreneurs now explore
technology transfer opportunities during the R&D stage without going through a standardization phasethat involves mass manufacturing in the North.

2

Our prime example in this context is Apple’s mini i-pod, the state-of-the-art MP3 player of its
time. When mini i-pod was introduced in 2002, the labeling at the back of the product read “designed in
California, manufactured in Taiwan”. In subsequent periods, the labeling for these i-pods remained thesame with one exception: Taiwan was replaced with China! There is no evidence that suggests that mass
production of mini i-pods has ever taken place in either California or anywhere else in the United States.
Globally-integrated innovation-production networks are increasingly becoming the defining feature ofmultinational companies. Other examples in this context come from a variety of industries such as Dell,
Hewlett-Packard Co., Motorola, and Philips, in electronics; and Glaxo-Smith-Kline and Eli Lilly inpharmaceuticals.1 Simultaneous design and outsourcing efforts are also prevalent in low-tech industries as
observed for clothing/footwear retailers such as Gap and Nike, and for household item makers such as
Williams Sonoma, and Crate and Barrel. Business Week calls such firms “Speed Demons” (March 27,
2006, pp 70-76), which often combine new R&D with immediate outsourcing and mass production in theSouth to take advantage of lower manufacturing costs and grasp the potential rents.2
The literature on endogenous technology transfer and growth has expanded substantially in thepast five years.3 One common feature is that firms can engage in transfer of technology only after
successful innovation. Thus, the existing literature misses the i-pod cycle which constitutes one major
aspect of multinationalization. Another feature of this literature is that firms have no choice over their expost manufacturing productivity levels. While in the real world, firms devote their R&D efforts not only1

See Naghavi and Ottaviano (2005) for an excellent discussion on the nature and extent of company-level globally integrated
production networks.
2
For instance, i-pod’s main components actually involve highly sophisticated products which can only be manufactured byestablished producers such as Toshiba and Fujitsu. The inventors of i-pod had a good idea to be put into immediate mass
production overseas and thus captured the rents.
3
Glass and Saggi (2001) analyze fragmented technology transfer to the South with endogenous innovation but without imitation.
Glass (2004) extends this fragmentation framework to allow for exogenous imitation. Glass and Saggi (2002) use a qualityladders growth model to study FDI, with both endogenous innovation and imitation but without fragmentation. Dinopoulos andSegerstrom (2005) study endogenous FDI and innovation in a scale-invariant endogenous growth setting without imitation. In a
most recent paper, Lu (2006) shows that the firm with the most advanced technology stays in the North, and the less advanced
moves to the South. Industries with high R&D productivity have more of the former firms, while those with medium R&D
productivity have more outsourcing firms.

3

to product innovation (which can be targeted at quality improvements or variety expansion) but also toprocess innovation (which is targeted at increasing manufacturing productivity).4
Thus, our objectives in this paper are twofold. One is to embed this i-pod cycle into a standard
North-South product-cycle framework, and the other is to incorporate both product and process
innovations into R&D races. We then study the effects of globalization and FDI policies on the rates ofinnovation, outsourcing and North-South wage differential.
Our North-South world economy consists of a continuum of industries. In each industry,
Northern entrepreneurs participate in R&D races to innovate higher quality products (product innovation).
In a typical industry, two types of R&D races take place simultaneously: local-sourcing-targeted- andoutsourcing-targeted- R&D races. The winner of the local-sourcing-targeted R&D race can only
manufacture in the North, facing higher labor costs. The winner of the outsourcing-targeted R&D race
can immediately manufacture in the South, enjoying lower labor costs. The Northern entrepreneurs
engaged in R&D must make two simultaneous decisions ex-ante. First, they choose the type of R&D race
to participate in (local-sourcing-targeted vs. outsourcing-targeted) and the intensity of their R&D
activities. Second, they choose their ex-post manufacturing efficiency levels (process innovation), which
in turn determine their R&D technology. Northern entrepreneurs targeting a higher manufacturing
productivity level ex-post must undertake more technologically-challenging R&D ex-ante, that is, morescientists and engineers employed per unit of R&D intensity.
In this setting, we capture the i-pod cycle in the context of the outsourcing-targeted-R&D race inwhich innovation and outsourcing efforts are simultaneously undertaken by Northern entrepreneurs.
Participation in an outsourcing-targeted R&D race requires engagement in a broadly-defined R&D
activity that involves not only scientists and engineers working on innovations but also a sophisticatedmanagement team that globally coordinates the innovation and technology transfer efforts of amultinational firm. In our setting, the Speed Demons correspond to the winners of the outsourcing-4

Scherer (1984) reports that 75.5 percent of R&D expenditures are allocated towards quality improvements and 24.5 percent are

4targeted R&D races. These firms realize lower production costs and thus higher profit margins and stock
market valuation. In a free-entry R&D equilibrium, it implies that participating in an outsourcing-directed
R&D race involves relatively higher investments in comparison to a local-sourcing-directed R&D race.
We capture the impact of globalization by considering an increase in the efficiency ofoutsourcing-targeted R&D activity. We find that this raises the rate of outsourcing-targeted innovation
but exerts an ambiguous effect on the rate of local-sourcing-targeted innovation. The aggregate rate ofinnovation (the sum of the two innovation rates) unambiguously increases. Also, the mass of outsourcing
firms increases and the North-South wage gap declines. Glass and Saggi (2001), Glass (2004) andDinopoulos and Segerstrom (2005) analyze similar issues, but in settings with only local-sourcingtargeted R&D races and thus do not address the compositional R&D effects of globalization as we do. Bymodeling two distinct R&D races, we find that the aggregate innovation rate increases despite thepossibility of a decline in local-sourcing directed R&D. In other words, we argue that the increased
intensity of outsourcing-directed R&D (i.e., the increased frequency of i-pod cycles) is a major growthpromoting factor triggered by globalization, which induces more outsourcing of multinational activities.
We then examine the effects of Southern FDI policies towards outsourcing by considering two
policy tools. One is manufacturing subsidies which reduce the ex-post production costs of outsourcing
firms. The other is technology transfer subsidies which facilitate the ex-ante production shifting efforts ofentrepreneurs engaged in outsourcing-targeted R&D. As expected, an increase in either type of subsidy
raises the aggregate innovation rate and diminishes the North-South wage gap. However, contrasting
results arise such that technology-transfer subsidies unambiguously increase the mass (number) of
outsourcing firms whereas manufacturing subsidies can reduce this measure under certain parametricrestrictions. Modeling of process innovations provides the key mechanism that generates this contrastingoutcome. Higher manufacturing subsidies reduce the incentives of Northern entrepreneurs to engage inlabor saving in the South. This leads to more employment within each outsourcing industry, putting

allocated to process innovations.

5

downward pressure on the mass of such industries. On the contrary, technology transfer subsidies being
directed at pre-production efforts of entrepreneurs do not trigger this type of labor-saving mechanism.
Note that since Glass and Saggi (2001), Glass (2004) and Dinopoulos and Segerstrom (2005) do notmodel process innovation, such contrasting implications of FDI policies do not arise in their models.
Our findings thus imply that technology transfer subsidies can be a better policy tool to attract
FDI vis-à-vis manufacturing subsidies. The former brings the desired effects without the possibility ofgenerating a compression in Southern production variety, an adverse outcome that may hinder knowledge
spillovers from outsourcing firms to indigenous Southern firms. Given the importance of such spillovers
in reaping the benefits of FDI (an issue heavily emphasized in the empirical literature), and the variety of
incentives offered by the governments to attract FDI, our distinction in policy outcomes can be ofpractical use to policy makers.5 In an extensive survey, Hanson (2001) classifies the policies to promote
FDI into two broad categories. The first consists of indirect subsidies that offer exemptions from
corporate taxes and import duties. These correspond to our manufacturing subsidies. The second consistsof direct subsidies that reduce the cost of all infrastructure associated with building the new plant (which
may involve building roads and ports to facilitate transportation, providing access to energy, the cost ofland for the plant itself and so on). These correspond to our technology transfer subsidies. Hanson statesthat indirect subsidies are more visible and thus frequently noted in the literature; however, direct
subsidies which are usually offered to firms on a case by case basis also appear to be common. As
specific examples Hanson (2001) identifies General Motors and Ford in Brazil, Honda in Turkey, Fordand Volkswagen in Portugal, and IBM and Citibank in Ireland. All of these multinational companies havereceived direct subsidies from the host governments to facilitate their technology transfer efforts.
From a theoretical point of view, our explicit modeling of process innovations brings forth two
main implications. First, in our setting lower cost production opportunities in the South arise due toNorthern entrepreneurs’ targeted labor-saving efforts and not necessarily due to lower Southern wages.

6

When it is easier to implement labor-saving technologies in the South, production costs in the South turnout to be lower vis-à-vis the North. This differs from the existing literature where wage differentials (notrelative North-South labor saving opportunities) are the primary cause of production cost differentials.
Second, our model establishes a substitution mechanism between Northern and Southern labor withineach industry in response to changes in the North-South relative wage. When this relative wage increases,
entrepreneurs engaged in local-sourcing-targeted R&D (whose efforts eventually leads to Northern
employment) raise their labor saving targets in comparison to entrepreneurs engaged in outsourcingtargeted R&D (whose efforts eventually leads to Southern employment). This is a new mechanism thatdiffers from the literature where labor productivity levels are fixed by exogenous parameters.
The present paper also complements an emerging literature in which contractual frictions play a
key role in determining plant location and whether production takes place within the boundaries of thefirm [Antràs, 2003, Antràs and Helpman, 2004, and Antràs, 2005]. In Antràs (2005), which is mostclosely related to our work, North-South product cycles emerge due to imperfect enforcement ofinternational contracts. Newly innovated products go through a gradual standardization process at anexogenous rate, and the arrival rate of new products is exogenous. In our model, standardization takes
place instantaneously via targeted R&D efforts and the arrival of new products is endogenous.
In addition, the present paper is closely related to the recent literature on outsourcing andfragmentation, which so far has focused mainly on why fragmentation and outsourcing occur. For
instance, Jones and Kierzkowski (1990) point out that the existence of fixed costs and thus increasing
returns favor integrated production at low outputs, but fragmentation at high outputs. Grossman andHelpman (2003) explain outsourcing as tradeoffs between production and search, the latter of which isaffected by market thickness and the contracting environment. Kohler (2004) develops a dual
representation of fragmentation technology, and investigates outsourcing in response to a decline in the
final output price of a multistage industry. Long, Riezman, and Soubeyran (2004) show that services link

5

Indeed, Blomström and Kokko (2003) provide abundant evidence not supporting across-the-board incentives to attract FDI,

7

production blocks, and allow the breaking up of integrated production. Free trade and the growth of theservice sector facilitate fragmentation and outsourcing. As a complement to the above, our model showsthat technology improvement is a driving force for the recent surge of multinational outsourcing activities.
The rest of the paper is organized as follows. Section 2 outlines the building blocks of the modeland establishes the steady-state equilibrium. Sections 3 and 4 present the comparative steady-state results.
Section 5 concludes. Proofs of all propositions are relegated to the Appendices available upon request.

2. The Model
We consider a world economy with two countries: the North and the South. There is a continuum of
industries indexed byω. The size of household population in country i at time t for i ∈ {N, S} is Li(t) =L0ient, where L0i is the initial level of population per household, and n > 0 is the rate of population growth.

2.1 Household behavior
In each country, there exists a continuum of identical households, which takes goods prices,
factor prices, and the interest rate as given and maximizes its utility over an infinite horizon,
∞

Ui=

∫ L e
i
0

– (ρ – n)t

log ui(t) dt ,for i = N, S,(1)0

where ρ is the subjective discount rate, and log ui(t) is the instantaneous utility of each household member
defined as:
log ui(t) ≡1∫ log [ Σ λ x (j,ω ,t)]dω ,
0

j

j

i

for i = N, S,(2)

where xi(j,ω,t) is the quantity demanded of a product with quality j in industry ω at time t. The size ofeach incremental quality improvement (the innovation size) is denoted by λ > 1. Therefore, the total
quality of a good after j innovations is λj.

because such FDI incentives alone are not sufficient to attract foreign technology.

8Each household in country i allocates its per capita consumption expenditure for each product line,
ci(t), to maximize ui(t) given prices at time t. Note that all products within an industry are perfect
substitutes; thus, households buy only the products with the lowest quality-adjusted prices. Products enter
the utility function symmetrically; therefore, households spread their consumption expenditure evenly
across goods. The resulting per capita product demand for each product line is xi(j,ω,t) = ci(t)/p, where pis the relevant market price for the product that has the lowest quality-adjusted price.
Given the static demand behavior, the household’s maximization problem over all product lines is
simplified to maximizing∞∫0L0i e – (ρ – n)t log ci(t) dt,

for i = N, S,(3)subject to the budget constraint B i (t) = Wi(t) + ri(t)Bi(t) – ci(t)Li(t), where Bi(t) denotes the financial
assets owned by the household, Wi(t) is the family’s expected wage income of the household and ri(t) is
the instantaneous rate of return. The solution to this optimization gives the standard differential equationc i ( t ) i= r (t) – ρ ,c i (t)for i = N, S.

(4)

At the steady-state equilibrium, ci remains fixed; thus, the market interest rate is equal to the subjective
discount rate: ri(t) = r = ρ. From this point on we will focus on the balanced-growth path behavior of theeconomy; hence, we drop the time index for the variables that remain constant.

2.2 Product Cycle Dynamics
All industries in the continuum are structurally identical. In each industry, Northern entrepreneurs
participate in R&D races to innovate higher quality products. Successful innovators gain access to thetechnology of producing the state-of-the-art quality products. Northern entrepreneurs can ex-ante choose
the type of R&D that will determine the eventual location of production if they become successful in
R&D. More specifically, Northern entrepreneurs choose between local-sourcing-targeted R&D whichleads to manufacturing in the North and outsourcing-targeted R&D which leads to manufacturing in the9South. We assume that no complementarity exists between the two types of R&D so that eachentrepreneur just focuses on one type.
All industries in the continuum are targeted by both outsourcing and local-sourcing directed R&D.
Entrepreneurs successful in R&D exercise temporary monopoly power in the global market. In thissetting, two types of industries can emerge: Northern industries and Outsourcing industries. The transition
rates between industries are governed by stochastic Poisson processes. Entrepreneurs successful in localsourcing-targeted R&D manufacture their top quality products using Northern resources. We refer to thistype of industries as Northern industries. In a typical industry, the probability of success in localsourcing-targeted R&D is ιNdt, where ιN denotes the intensity of local-sourcing-targeted R&D and dt
represents a small interval of time. Entrepreneurs successful in outsourcing-targeted R&D shift
production to the South instantaneously and use the South as a platform to supply to the world market.
We refer to such industries as Outsourcing industries. In a typical industry, the probability of success inoutsourcing-targeted R&D is ιOdt, where ιO is the intensity of outsourcing-targeted R&D.

2.3 Stock Market Valuations
Given the above product cycle dynamics, it is straightforward to derive the stock market
valuations of firms. Consider first the determination of VN(t), the value of a successful Northern innovator
producing in the North. Over a time interval dt, the stockholders of this firm receive πN(t) as dividend
payments. With probability (ιO + ιN) dt, further innovation may take place in this industry. In this eventthe stockholders realize a loss of VN(t). With probability 1 – (ιO + ιN)dt, no further innovation takes place,and the firm’s valuation changes by VN dt. Investors fully exploit the arbitrage opportunities; thus the
expected rate of return from a stock issued by a Northern firm must be equal to the risk-free market
interest rate ρ(t). This implies (taking limits as dt → 0):
V N ( ω ,t ) =π N (t )ρ + ι N + ι O − [ VN ( t ) / V N ( t )]

(5)

10

Consider now the valuation of an Outsourcing firm VO(t). Over a time interval dt, thestockholders of this firm receive πO(t) as dividend payments. With probability (ιO + ιN) dt, further
innovation may take place in this industry and the stockholders realize a loss in value of VO(t). With
probability 1 – (ιO + ιN) dt, the outsourcing firm maintains its leadership position, and the firm’s valuechanges by VO ( t ) . Again, the no-arbitrage condition requires (taking limits as dt → 0):
VO ( ω , t ) =πO(t )

ρ + ι N + ι O + [ VO ( t ) / VO ( t )].

(6)

2.4 Manufacturing and Product Markets
In Northern industries, the unit labor requirement in final good manufacturing is mN. Hencemarginal cost of production is MCN = mNw. In Outsourcing industries, the unit labor requirement is mO.
Since the wage rate in South is normalized to one, the marginal cost of production is: MCO = mO(1 – σO),
where σO is the subsidy rate for outsourced manufacturing. Following the literature, we assume that every
time an innovation takes place in the North, some technology diffusion takes place. More specifically, theinferior technology becomes common knowledge to all firms in the global economy.6 For follower firms,
who have access to the one-step-down technology, the unit labor requirement of production is set to one
without loss of generality. We restrict attention to the steady-states in which i) Northern producers realize
positive profits, ii) marginal manufacturing costs in the North are higher than those in the South iii) the
Northern relative wage satisfies w > 1. Hence, manufacturing costs must comply with:

λ > MCN > MCO > 1⇒

λ > mNw > mO( 1 – σO) > 1.

(7)

With w > 1, the Southern followers can always undercut their Northern counterparts in a Bertrand
pricing game. That is, only Southern followers can effectively compete with Northern quality leaders. In atypical product market, a Northern quality leader charges the limit price λMCS – ε = λ – ε (where ε is an

6

See for instance see Glass and Saggi (2001) and Sayek and Sener (2006).

11

infinitely small positive number) and drives the Southern followers out of the market. Thus, the profit
flow of a quality leader manufacturing in the North is:

π N (t )=E( t )λ( λ − MC N ) ,(8)where E(t) = cNLN(t) + cSLS(t) stands for the global consumption expenditure in each product line.
Similarly, the profit flow of a quality leader outsourcing production to the South is:πO(t ) =E( t )λ( λ − MC O ) .

(9)

Since MCN > MCO, we must have π O > π N , which implies that outsourced production generates larger
profit flows compared to local production.

2.5 Endogenous Labor Saving Technology
Northern entrepreneurs employ Northern workers to perform R&D activities. Let XN and XO
denote respectively the difficulty of conducting local-sourcing- and outsourcing-targeted R&D. These are
introduced to remove the scale effects from the endogenous growth setting. The unit labor requirement
for the two types of R&D can be written respectively as aNXN and aOXO. Further denote with mO and mN
the unit labor requirement in manufacturing of final goods for Outsourcing and Northern industries
respectively. In addition to their ex-ante choice of which R&D race to participate in (local-sourcing
or outsourcing-directed R&D race), each entrepreneur determines its ex-post manufacturing productivity
level by choosing ex-ante the challenge level for its R&D activity. Specifically, as the target level of midecreases (i.e., manufacturing productivity increases) for i ∈ {N,O}, it becomes more challenging toinnovate and thus the unit labor requirement per unit of R&D activity ai increases. This scheme iscaptured by the following specification:ai(mi),

with ai′(mi) < 0 and ai ″(mi)> 0

for i ∈ {N,O}.

The second derivative being positive implies that as mi falls, it becomes more challenging to generate agiven decline in mi and thus a larger increase in ai is required.

12

To obtain closed form solutions we assume:ai(mi) = Aimi – φi,for i ∈ {N,O},(10)

where Ai > 0 is a constant. And φi > 0 is the elasticity that measures the percentage change in ai(mi)divided by the percentage change in mi, because:ai ′ ( mi )mi= −φi .
ai ( mi )for i ∈ {N,O}.

(11)

The lower the level of φi, the larger is the labor-saving efficiency of the R&D technology.
A few points of clarification can be made here. As in the standard quality-ladders growth
literature, success in R&D implies that the entrepreneur gains access to the technology of producing a
product that is λ times better than the existing one (product innovation). Moreover, firms can target their
R&D efforts at labor saving (process innovation). By intensifying these efforts, firms can realize gains in
profit margins and thereby raise their stock market valuations. However, engaging in labor-saving
technology is costly as reflected in increased R&D resource requirements. As we will see below, theoptimal level of mi will be derived from an optimality condition which equates the incremental gain in
firm valuation to the incremental increase in R&D costs.7

2.6 Optimal Choices of R&D Intensities and Productivity Targets
We normalize the wage rate in the South to one and define w as the wage rate of Northern labor
relative to Southern labor. A typical entrepreneur firm indexed by j engaged in local-sourcing-targeted
R&D chooses its target manufacturing productivity level mN to maximize:
VN(mN, t)ιNj dt – waN(mN) XN(t)ιNjdt.
The first order condition for mN is (for an interior solution): 8This is in the same spirit as Grossman and Helpman (1991, p. 100) who endogenize innovation size λ. In contrast, we
endogenize production technology, which is more relevant to issues involving outsourcing. Glass and Saggi (2002) also haveendogenous innovation size and consider licensing and direct investment in a symmetric two-country economy.
8
The second order condition (soc) for a maximum is VN″ (mN) – w XN(t) aN″ (mN) < 0, which holds with VN″ = 0 and a N″ > 0.
7

13

∂V N
∂a
= w N X N (t ).
∂m N
∂m N

(12)

Free-entry in local-sourcing-targeted R&D races drives expected profits down to zero. Thus,
VN(t) = waN XN(t).

(13)

Similarly, a typical entrepreneur firm engaged in outsourcing-targeted R&D chooses its target
manufacturing productivity level mO to maximize:
VO(t)ιOj dt – waO(mO) (1 – σι O)XO(t)ιOj dt,
where σιO is the subsidy rate for outsourcing-targeted R&D. The first order condition for mO is: 9∂VO∂a= w O ( 1 − σ ι O )X O ( t ) ,
∂mO
∂mO

(14)

Free-entry in outsourcing-targeted R&D races drives expected profits down to zero. Thus,
VO(t) = waO(1 – σι O)XO(t) .

(15)

2.7 Equilibrium Levels of Manufacturing Productivity
From the equation pairs (12)-(13) and (14)-(15), it immediately follows that:Vi′ a i′=
Vi a ifor i ∈ {N,O},(16)

where Vi′= ∂Vi/∂mi and ai′ = ∂ ai /∂mi. One can obtain expressions for VN′/VN and aN′/aN from (5) and (11),respectively. Substituting these into (16) and solving for mN gives the optimal level of mN as:mN ( w ) =λφ N.
w( 1 + φ N )(17)where ∂ mN/∂w < 0. Similarly, one can obtain expressions for VO′/VO and aO′/aO from (6) and (11)respectively. Substituting these into (16) and solving for mO gives the optimal level of mO as:
mO =

λφO

( 1 + φO )( 1 − σ O )

.

(18)

14

It follows that the relative unit labor requirements between local and outsourced manufacturing is

mN
=
mO

⎛

⎞

⎝

φO ⎠

(1 − σ O )⎜⎜ 1 + 1 ⎟⎟⎛1 ⎞⎟⎟w⎜⎜ 1 +⎝ φN ⎠(19)

Lemma 1: As the Northern relative wage w increases, entrepreneurs raise their relative labor-saving
targets in the North, which translates into a reduction of mN/mO, i.e., the North-South ratio of the unit
labor requirement in manufacturing falls.

Lemma 1 establishes an endogenous substitution mechanism between Southern and Northernlabor within each industry. To the best of our knowledge, such a mechanism has not been considered inexisting R&D-based North-South product-cycle models, where mN and mO are fixed by construction.
Substituting for mN and mO in (7) using (17) and (18), we find that MCN > MCO if and only if φN> φO. Recall that φi is an elasticity term that measures the percentage change in ai(mi) divided by thepercentage change in mi. Hence, the condition φN > φO implies in percentage terms that a given increase in
the challenge of R&D generates a larger productivity gain in outsourced production compared to locallysourced production.

Lemma 2: Low cost production opportunities in the South are endogenously tied to the degree withwhich implementability of labor-saving technologies differ between the North and the South. When it iseasier to implement labor-saving technologies in the South relative to the North, i.e., φN > φO, production
costs become lower in the South than in the North.10

9

Note again that the soc for a maximum is VO″ (mO) – w XO (t) aO″ (mO) (1 – σO)< 0, since VO″ = 0 and a O″ > 0 hold.

15

Combining (18) with mO(1 – σιO) > 1 from (7) implies the restriction φO > 1/[λ/(1 – σO) – 1],
which we assume to hold. Note that for σO = 0, this requires φO > 1/(λ – 1). Hence, if λ < 2, we need tohave φO > 1; and if λ > 2, we need to have φO < 1. Using (17) and (18) we obtain the unit labor
requirements in local-sourcing- and outsourcing-targeted R&D as⎞⎛ λφ N⎟⎟aN(w) = AN ⎜⎜⎝ w( 1 + φ N ) ⎠

−φ N

⎞
⎛
λφ O
⎟⎟
and aO = AO ⎜⎜⎝ ( 1 + φ O )( 1 − σ O ) ⎠

−φO

,

(20)

where AN and AO are constants as given in (10).
Note that from (17) and (18) the profit margins of a Northern and a Southern firm can be
simplified as:

λ − MC N =λ
λand λ − MC O =.
( 1 + φN )( 1 + φO )(21)

2.8 Industry flows
Denote with nN and nO the fraction of Northern and Outsourcing industries, respectively. Constantindustry shares at the steady-state require that flows in and out of each industry must be exactly balanced.
Consider the Northern industries. Every time a Northern entrepreneur participating in an outsourcingtargeted R&D race that is directed at a Northern industry becomes successful, the Northern industry istransformed into an Outsourcing industry. Hence, the aggregate flow out of the Northern industry pool isιOnN. On the other hand, every time a Northern entrepreneur participating in a local-sourcing-targeted
R&D race that is directed at an Outsourcing industry becomes successful, the industry to which the R&D
is directed becomes a Northern industry. Thus, the aggregate flow into the Northern industry pool is ιNnO.
Constant nN requires:
nOιN =ιOnN .

(22)

Finally, we have

10

Note that when φN > φO, for local-sourcing directed R&D to take place, we also need kNL(t) aN(mN) < kOL(t)aO(m0) to hold. In

16

nN + nO = 1,

(23)which ensures that nO also becomes constant.

2.9 Labor Markets
In the North, the labor market equilibrium implies:
LN(t) = ιNaNXN(t) +ιOaOXO(t) + nN(E(t)/λ)mN,(24)

where ιNaNXN(t) and ιOaOXO(t) respectively capture the labor demand coming from local-sourcing andoutsourcing-targeted R&D, and nN(E(t)/λ)mN measures the manufacturing labor demand coming from
Northern industries.
In the South, the labor market equilibrium implies:
LS(t) = nO(E(t)/λ)mO,(25)

where nO(E(t)/λ)mO measures the manufacturing labor demand coming from Outsourcing industries.

2.10 Steady-State Equilibrium
We begin the steady-state analysis by removing the scale effects in the spirit of Dinopoulos andThompson (1996, 2000). In particular, we set XN(t) = kNL(t) and XO(t)= kOL(t), where kN > 0, kO > 0 and
L(t)= LS(t) + LN(t). With scale effects removed the system can now be expressed in per capita terms.
Define per capita consumption expenditure of a representative global citizen as c(t) ≡ E(t)/L(t), and thesize of the Southern population relative to the Northern one as ηS ≡ LS(t)/ LN(t). It follows that LN(t)=L(t)/(1+ηS) and LS(t) = L(t)ηS/(1+ηS).
At the steady-state equilibrium aN, aO, ιN, ιO, nN, nO, w, and c remain constant whereas VN(t), VO(t),XO(t), XN(t), πN(t), πO(t), E(t) grow at the rate of n. All of these variables are endogenously determined.

the Appendix we show that this condition indeed holds under φN > φO.

17

Using the flow conditions (22) and (23), the industry fractions can be expressed in terms of theendogenous variables ιN and ιO:nN =ιNι N + ιO

, nO =

ιO(26)

ι N + ιO

Substituting the industry fractions from (26) into (24) and (25), using the specifications for XO(t)and XN(t) along with c(t) ≡ E(t)/L(t), LN(t)= L(t)/(1+ηS) and LS(t)=L(t)ηS/(1+ηS), one can express theNorthern and Southern labor market conditions in four unknowns c, w, ιN and ιO.
1/(1+ηS) = ιN aN (w) kN +ιO aO kO + nN(ιN, ιO) (c/λ) mN(w),(c,ιN, ιO, w)(27)

ηS/(1+ηS) = nO(ιN, ιO) (c/λ)mO.

(c,ιN, ιO)(28)

To complete the system, we need to use the stock market valuation and zero-profit conditions for localsourcing and outsourcing-targeted R&D. Substituting VN(t) from (13) and πN(t) from (8) into (5) using(21) and c(t) ≡ E(t)/L(t) gives:
wa N ( w )k N =c /( 1 + φ N ).
ρ + ι N + ιO − n(c,ιN, ιO, w)(29)

Similarly substituting VO(t) from (14) and πO(t) from (9) into (6) using (21)and c(t) ≡ E(t)/L(t) gives:
wa O ( 1 − σ ι O )k O =c /( 1 + φ O ).
ρ + ι N + ιO − n(c,ιN, ιO, w)(30)

Conditions(27)-(30) constitute a system of four equations in four unknowns (c,ιN, ιO, w). The rest of theendogenous variables can be derived in a recursive fashion using the equilibrium levels of (c,ιN, ιO, w).
We label the steady-state equilibrium levels by “*”. We obtain an expression for w by taking ratioof the zero-profit conditions in outsourcing and local-sourcing targeted R&D, equations (29) and (30),respectively. This yields:Κ≡a N ( m N ( w )) k N 1 + φ O=≡Π ,a O ( mO )( 1 − σ ι O ) k O 1 + φ N

(31)

18

Κ measures the relative unit cost between local-sourcing and outsourcing targeted R&D, whereas Π
measures the relative profit margin between locally-sourced and outsourced production

λ − MC N. Noteλ − MC O

that ∂(aN(w)/aO)/ ∂w > 0; thus, K is an increasing function of w, as shown by the upward sloping curve in
Figure 1. Intuitively, an increase in w raises Northern production costs and induces entrepreneurs engaged
in local-sourcing-targeted R&D to raise their productivity targets (i.e., a fall in mN). This in turn renders
local-sourcing-targeted R&D more challenging and thus increases the relevant resource requirement

aN(w) . On the other hand Π does not respond to variations in w and is shown by a horizontal curve in
Figure 1. The intersection of the two curves determines the equilibrium level w*. Observe that byequation (31) any parameter change that leads to an increase in the profitability of local-sourcing directed
R&D relative to outsourcing-targeted R&D raises the Northern relative wage w*. Also when φN > φO, wehave Κ < 1, implying that participating in an outsourcing-targeted R&D case is more costly thanparticipating in a local-sourcing-targeted R&D.
We can obtain a closed form solution for w* by substituting for aN(w) and aO from equation (20)
into (31), which gives:⎛⎞
λφ N ⎛⎜( 1 + φN )
λφ O
⎜⎜
⎟
w* =
( 1 + φ N ) ⎜ AR k R ( 1 − σ ι O )( 1 + φ O ) ⎝ ( 1 − σ O )( 1 + φ O ) ⎟⎠
⎝

φO

⎞
⎟
⎟
⎠

−1 / φ N,(32)

where AR ≡ AO/AN and k R ≡ kO/kN. Observe that w is pinned down by the parameters of the model.
Substituting for w* from (32) into (17)~(20) immediately gives the equilibrium levels of mi* and ai* for i∈ {N,O} in terms of the parameters as well. For future use, we note the partial derivatives with respect tothe parameters of interest AR, σιO and σO.
+−−

a N * = a N ( AR ,σ ιO ,σ O )−−+m N * = m N ( AR ,σ ιO ,σ O )

+

−

0

a O * = a N ( AR ,σ ιO ,σ O )00+

mO * = mO ( AR ,σ ιO ,σ O )Next, we substitute w* from (32) into (28), to express c in terms of (ιN, ιO). This yields:

(33a)
(34b)

19

φO
⎛
⎛
⎞ ⎞⎟
( 1 + φN )
λφ O
⎜
⎜
⎟
c( ι N ,ι O ) = ( ρ + ι N + ι O − n )φ N AN k N λ⎜ AR k R ( 1 − σ ιO )( 1 + φ O ) ⎜ ( 1 − σ O )( 1 + φ O ⎟ ⎟
⎝
⎠ ⎠
⎝
+

+

+

−

− ( 1+ φ N ) / φ N

(34)

−

Note that c( ι N ,ι O ) = c( ι N ,ι O , AR ,σ ιO ,σ O ) .
Substituting for c from (34) into (27), we can express the Northern and Southern labor market
equilibrium conditions solely in terms of ιN and ιO
+ −
+ +
1
=
ι
a
*
k
+
ι
a
*
+
[
n
(
ι
,
ι
)
c
(
ι
N N
N
O O
N
N O
N ,ι O ) m N * / λ ] ,1 +η S

(35)

− +
+ +
ηS
=
n
(
ι
,
ι
)
c
(
ι
O
N
O
N ,ι O ) mO * / λ .
1 +η S(36)

where ai* and mi* for i ∈ {N,O} are as in (33a) and (34b), and nN and nO come from (26).
We are now in a position to establish the steady-state equilibrium by plotting (35) and (36) in (ιN,ιO) space. To simplify the exposition, we will evaluate the derivatives and intercepts as the net discountrate ρ – n approaches zero. This is a standard assumption commonly invoked in quality-ladder models of
growth.11 We conducted extensive numerical simulations to check the robustness of our results. Unlessotherwise noted, the main results are robust to assuming positive levels for ρ – n.
Equation (35), which summarizes the Northern labor market equilibrium, identifies a downward
sloping curve in (ιN, ιO) space labeled as LN in Figure 1. For a given ιO, a higher ιN affects the Northernlabor demand via three channels. First, it raises the level of employment in local-sourcing-targeted R&D

ιN aN kN . Second it increases the proportion of Northern industries nN. These two effects work to raise theNorthern labor demand. Third, a higher ιN indirectly puts upward pressure on per capita consumption
expenditure c and thus reinforces the increased Northern labor demand. To see this, note that a higher ιN
increases the replacement rate within each industry and thus lowers the stock market valuation of firms.
Maintaining the zero-profit conditions in R&D requires an increase in c [equation (34)]. To sum up,

11

See for instance Glass and Saggi (1999, 2002) among others.

20

restoring equilibrium calls for a fall in ιO, which reduces the level of employment in outsourcing-targeted
R&D ιO aO kO and thus the demand for Northern labor. The lowered ιO also exerts two competing effects
on the Northern labor demand by increasing nN and reducing c (via the same replacement channel
discussed for ιN). However, as ρ – n → 0, these two effects exactly cancel out. To sum up, equation (35)implies an inverse relationship between ιO and ιN. Hence, the downward sloping LN curve in Figure 1.
Equation (36), which summarizes the Southern labor market equilibrium, identifies a vertical linein (ιN, ιO) space labeled as LS in Figure 1. For a given ιO, a higher rate of local-sourcing-targeted R&D ιN
triggers two opposing forces on the Southern labor demand: it reduces the proportion of Outsourcing
industries nO and thus the Southern labor demand, but raises the replacement rate and thus increases thelevel of c that is required to maintain the R&D zero profit condition. When ρ – n → 0, these two forces
exactly offset each other and thus variations in ιN exert no influence on equation (36). This implies thatthe equilibrium level of ιO is solely determined by (36). Hence the vertical LS curve in Figure 1.12 , 13

3. Comparative Steady-State Analysis
3.1 Globalization in the form of a decline in AO
We first examine the case of a decline in AO which reflects an increase in the efficiency of outsourcingtargeted R&D. It leads to a fall in AR ≡ AO/AN . This exercise is motivated by the substantial decline in

The existence and uniqueness of the equilibrium can be easily established by evaluating the limits when ρ – n → 0. To simplify
notation, we set the subsidy rates σιO = σO = 0. On the LN curve as ιO → 0, ιN → 1/[(1+ηS)(aN*kN + ΛmN*)], where Λ ≡

12

1+φ N

( AR k R )φN−φO ( 1+φ N )λφNΓ , and as ιN → 0, ιO → 1/[(1+ηS)aO* kO*]. On the LS curve ιO → ηS /[(1+ηS) ΛmO*]. The

necessary and sufficient condition for uniqueness is 1/[(1+ηS)aO* kO*] > ηS /[(1+ηS) ΛmO*]. Substituting in the relevantφO⎛⎛ λφ O ⎞ ⎞⎟( 1 + φN )⎜⎜⎟expressions this condition boils down to: λφ N φ O > η S ( 1 + φ N )⎜ ( 1 + φ O )( AR k R ) ⎜⎝ 1 + φ O ⎟⎠ ⎟⎝⎠1 / φN.

13
Combining the wage equation (32) with the existence and uniqueness condition above implies w* > ηS. In words, when theexistence and uniqueness condition is satisfied, the Northern wage turns out to be larger than the Southern wage if and only if theSouth is more populated than the North, a condition which has real world relevance.

21

transportation and communication costs observed in the past three decades, which we view as the main
factor that facilitated the simultaneous innovation-outsourcing efforts of Northern entrepreneurs.14

PROPOSITION 1: An increase in the efficiency of outsourcing-targeted R&D captured by a fall in AO,

a. reduces the wage rate of Northern labor relative to Southern labor w*,
b. increases the rate of innovation in outsourcing-targeted R&D ιO*,c. increases the rate of innovation in local-sourcing-targeted R&D ιN* iff ιN/ιO > 1/[φN(1+φO)](1 –σιO),d. increases the aggregate rate of innovation ιA*,e. increases the proportion of Outsourcing industries nO,
f.

increases the labor requirement in local-sourcing manufacturing mN and leaves the resource
requirement in outsourcing manufacturing mO the same; thus, mN*/mO*increases.

Proposition 1 shows that technology improvement is a driving force for the recent surge ofmultinational outsourcing activities, which complements the explanations offered in the existing literature,such as Jones and Kierzkowski (1990), Long, Riezman, and Soubeyran (2004), and Grossman andHelpman (2003), etc. Note also that in Glass and Saggi (2001), Glass (2004) and Dinopoulos andSegerstrom (2005), there is only local-sourcing-targeted R&D race, and thus they do not address thecompositional R&D effects of globalization.
Now let us identify the wage impact using (31). A decline in AO triggers a fall in aO/aN and thereby
increases the profitability of outsourcing-targeted R&D relative to local-sourcing-targeted R&D. For agiven w, the K curve in Figure 2 shifts up. Equilibrium is restored via a fall in w*, which reduces therelative profitability of outsourcing-targeted R&D because ∂ [waN(w)/aO]/ ∂w > 0.

14

See Tang (2006, Figures 2 and 3) for detailed evidence on declining transport and communication costs, and Feenstra (1998)
for a discussion of how such cost declines improve the efficiency of international outsourcing.

22

The reduction in w* discourages the labor-saving efforts of Northern entrepreneurs engaged in localsourcing-targeted R&D. As a result, the relative unit labor requirement between locally-sourced andoutsourced manufacturing mN*/mO* increases [See equation (19)]. With less ambitious productivity
targets, entrepreneurs engaged in local-sourcing-targeted R&D can now hire fewer units of scientists andengineers per unit of R&D. This implies a reduction in the relative R&D labor requirement aN*/aO*. Notethat with Southern wages normalized to one, mO and aO do not actually respond to variations in w*. Thus
the relative increase in mN*/mO* translates into an absolute increase in mN* and the relative decrease inaN*/aO* implies an absolute decrease in aN*.
Before analyzing the labor market effects, it is useful to examine the change in c holding ιN and ιO
constant. The reduction in w* induced by the lower AO decreases the R&D costs. To maintain the zeroprofit condition in R&D implied by (29) and (30), there must be a fall in the rewards coming from sales
and hence a decline in c.
Next, we examine the changes in ιN* and ιO* by identifying the shifts in LN and LS. Holding ιN andιO constant, we observe from (35) which characterizes the LN curve that a fall in AO affects the Northernlabor demand via four channels. First, a lower AO directly reduces aO and thus the labor demand comingfrom outsourcing-targeted R&D. Second, the reduction in aN* induced by a lower AO decreases the labordemand coming from local-sourcing-targeted R&D. Third, the increase in mN* induced by a lower AO
raises the demand for Northern manufacturing labor. Fourth, the downward pressure in c triggered by thelower AO reduces product sales and thereby the demand for Northern manufacturing labor. It follows from(34b) and (34) that cmN* declines. The last two effects combined lead to reduced labor demand, and as aconsequence, the sum of all effects lowers the demand for Northern labor. For a given ιO, this relaxes theNorthern resource constraint, allowing for an expansion in local-sourcing-targeted R&D ιN. Hence, theLN curve shifts to the right.

23

For the LS curve, defined by (36), the only effect of a fall in AO works through the induced
decline in c, which reduces the demand for Southern manufacturing labor. This generates room for an
expansion in outsourcing-directed R&D activity ιO and thus the LS curve shifts to the right.
Figure 2 shows that a lower AO unambiguously increases ιO*. On the other hand, the change inιN* appears to be indeterminate. Further algebra reveals that ιN* increases if and only if ιN/ιO >1/[φN(1+φO)]. With regards to industry configuration, we observe that the higher ιO* puts upward
pressure on the equilibrium share of Outsourcing industries nO*, whereas the change in ιN* counteracts
this effect if ιN/ιO > 1/[φN(1+φO)] and reinforces it otherwise. Comparative statics results imply that nO*
unambiguously increases. Obviously, with nO + nN = 1, the equilibrium share of Northern industries nN*
declines. Observe that nO* and mN*/mO* both increase in response to the fall in AR. These findings imply
that more labor-saving in Southern production and more outsourcing can occur concurrently. Also, wefind that the aggregate innovation rate ιA* = ιN* + ιO* unambiguously increases despite that the rise in ιO
increases ιA whereas the change in ιN may reinforce or counteract this effect.
Our findings may seem similar to Dinopoulos and Segerstrom (2005) and Glass and Saggi (2001)
in that these papers also find that an increase in the efficiency of technology transfer reduces the NorthSouth wage gap, increases the mass of Outsourcing industries and the aggregate innovation rate. However,in this literature, technology transfer takes place only after Northern production, and only local-sourcingtargeted R&D races are considered. Our modeling of two types of R&D races sheds light on thecompositional effects of globalization on R&D. We find that due to globalization, Northern entrepreneurs
intensify their simultaneous innovation-outsourcing efforts and this may come at the expense of the R&D
efforts that target the North for production purposes. Nevertheless, the aggregate innovation rateunambiguously increases and both the Northern and Southern consumers enjoy faster product quality
improvements. Hence, skeptics of globalization could be correct in fearing that increased globalization
may lead to a fall in the type of R&D that targets the North for production purposes. However, our model

24

clearly shows that globalization raises the aggregate innovation rate. This is mainly driven by theintensified outsourcing-targeted R&D efforts and hence the increase in the i-pod cycle frequency.
How robust is Proposition 1 to adding imitation as an additional channel of technology transfer?
In our accompanying working paper (Sener and Zhao, 2006), we consider this scenario by assuming that
outsourced industries are subject to imitation threat from the South. Extensive numerical simulations
showed that under a wide range of parameters the findings in Proposition 1 remain intact.

3.2 Changes in Outsourcing policies of the SouthWe consider two policy changes towards outsourcing that can be undertaken by the Southerngovernments. Southern governments may increase the manufacturing subsidy rate σO or the technology
transfer subsidy rate σιO. These are two distinct policies that certainly lie within the policy palette ofSouthern government (see Hanson, 2001). A higher σO may involve providing larger tax breaks or larger
subsidies in manufacturing upon successful technology transfer. A higher σιO on the other hand may
involve reducing the technology transfer costs prior to success in outsourcing. Such costs involve locating
the appropriate production site, setting up the production facility, matching with the production workers,
dealing with legal/financial transactions and etc.

PROPOSITION 2: An increase in the manufacturing subsidy rate to outsourcing firms σO,a. reduces w*,
b. increases ιO* if and only if φO > 1 – [1 /(1 + φN)],c. increases ιN*,d. increases ιA*,e. decreases nO*,f.

increases both mN and mO, while reducing mN/mO.

25

A higher σO reduces the labor saving incentives of Northern entrepreneurs participating inoutsourcing-targeted R&D races and thereby renders this type of R&D less challenging, leading to a fallin the relevant resource requirement; that is, mO increases and aO falls. As a result, the profitability ofoutsourcing-targeted R&D relative to local-sourcing-targeted R&D increases. The Κ curve in Figure 3
shifts up and w* decreases.
Before analyzing the labor market equilibrium effects, we investigate the impact on resource
requirements. As noted above, mO increases and aO falls. On the other hand, the lower w* reduces thelabor saving incentives of Northern entrepreneurs participating in local-sourcing-directed R&D races andthereby relaxes the resource requirement in this type of R&D; that is, mN increases and aN falls.15 It is also
useful to investigate the impact on c, holding ιN and ιO constant. The fall in w* induced by a higher σO
increases the profitability of R&D. For given levels of ιN and ιO, this puts upwards pressure on the level ofc that maintains the zero profit condition in R&D.
In the Northern labor market, we observe four effects. The lower levels of both aN and aO
decrease the labor demand coming from R&D activities. The fall in c reduces the demand for laborcoming from manufacturing whereas the rise in mN works to increase it. It can be shown that cmN declines.
Consequently, a larger σO reduces the aggregate labor demand in the North via both manufacturing and
R&D channels. For a given ιO, this relaxes the labor constraint in the North and generates room for an
increase in local-sourcing-targeted R&D activity ιN and hence the LN curve shifts up in Figure 3.
In the Southern labor market, we observe two competing effects. The reduction in c reduces thedemand for labor whereas the rise in mO increases it. Further algebra reveals that cmO falls if and only if

φO > 1 – [1 /(1 + φN)]. Recall that for the model to be well behaved, we must have φO > 1 if λ < 2 and φO< 1 if φO < 1. In the former case (λ < 2 and φO > 1), it follows that φO > 1 – [1 /(1 + φN)] is readily

15

It can be shown that the mN/mO ratio declines.

26

satisfied. Thus restoring equilibrium requires a rise in ιO and therefore a rightward shift of the LS curve in
Figure 3. In the latter case (λ > 2 and φO < 1) the “if and only if” condition for φO applies.16
Even though the change in ιO appears to be ambiguous because of the indeterminate shift of theLS curve, further algebra reveals that ιN unambiguously increases (actually iff φN > φO which we
assumed). The increase in ιN puts downward pressure on nO, and the change in ιO may reinforce or
mitigate this effect. We find that despite the indeterminate impact coming from ιO, nO falls (again iff φN >φO). This is quite an unexpected result because it implies that subsidizing outsourced production moreleads to a fall in the fraction of Outsourcing industries! Technically, even if ιO increases and puts upward
pressure on nO, it falls short of overturning the impact coming from the increase in ιN. The key mechanism
here involves the endogenous labor-saving decisions of firms. Increased manufacturing subsidies by theSouth reduce the labor-saving incentives of outsourcing firms. This leads to more labor employment

within each industry. To restore equilibrium, the mass of outsourcing industries nO must go down.
Through numerical simulations we find that this downward pressure on nO is mitigated as ρ – n increases.
Indeed when ρ – n increases above a certain level, an increase in σO raises nO.
What happens to the aggregate innovation rate ιA? Even though the change in ιO depends on theparameters of the model, the increase in ιN turns out to be sufficiently strong to unambiguously raise theaggregate innovation rate ιA.

PROPOSITION 3: An increase in the rate of technology transfer subsidies σιO,a. reduces w*,
b. increases ιO*,c. increases ιN* iff ιN/ιO > (1+φN )/[φN(1+φO)(1 -σιO)],d. increases ιA* if σιO < φO/(1 + φO),

16

Note that with φN > φO we are essentially looking at a particular range φN > φO > 1 – [1 /(1 + φN)] for this condition to hold.

27

e. increases nO*,f.

increases mN, leaves mO unchanged.

First, we investigate the impact on w*. An increase in σιO directly raises the relative profitabilityof outsourcing-targeted vs. local-sourcing-targeted R&D; hence the Κ curve in Figure 4 shifts up and w*
decreases. Before analyzing the labor market equilibrium effects, we examine the changes in resource
requirements. The lower w* reduces the labor saving incentives of entrepreneurs engaged in localsourcing-targeted R&D, rendering this type of R&D less challenging. In other words, mN increases and aNfalls. On the other hand, the change in σιO does not affect mO and aO. It is again useful to investigate theimpact on c, holding ιN and ιO constant. The lower w* increases the profitability of both types of R&D,
and restoring the zero profit condition puts downward pressure on c.
In the Northern labor market, we observe three effects. The fall in aN induced by the lower w*
reduces the labor demand coming from outsourcing-targeted R&D. The lower c reduces the labor demand
coming from manufacturing, whereas the higher mN works against it. It can be shown that cmN declines.
Consequently, the aggregate demand for Northern labor declines via both R&D and manufacturing
channels. For a given ιO, the relaxation in the Northern labor constraint creates room for an increase in ιN.
As a result, the LN curve shifts to the right in Figure 4. In the Southern labor market, the decline in c isthe only distortion. The lower c reduces the labor demand in manufacturing and relaxes the Southernlabor constraint. As a result, ιO increases and the LS curve shifts to the right in Figure 4.
It can be seen graphically from Figure 4 that ιO unambiguously increases. Further algebra reveals
that ιN increases if and only if ιN/ιO > (1+φN )/[φN(1+φO)(1 – σιO)]. The increase in ιO raises nO whereas
the change coming from ιN is indeterminate. In the Appendix we show that nO increases unambiguously.
In addition, we find that ιA increases if σιO is sufficiently low.
What are the policy implications of Propositions 2 and 3? Higher technology-transfer subsidies in
the form of an increase in σιO certainly attract FDI by increasing the frequency of i-pod product cycles ιO

28

and the mass of outsourcing industries nO. When one considers the possibility of knowledge spillovers
from Outsourcing industries to indigenous Southern firms, the positive effects of higher nO are magnified.
In fact, these spillovers can be seen explicitly when we allow for imitation µ > 0 (see Sener and Zhao,
2006). Then µ nO measures the flow of North-South knowledge spillovers that occurs through theSouthern production variety channel nO. Extensive numerical simulations implied that when µ > 0, themain results in Proposition 3 remain intact.
On the other hand higher manufacturing subsidies in the form of an increase in σO may not be theoptimal policy to attract FDI. This increase raises the frequency of i-pod cycles ιO only under certain
parametric restrictions and leads to a fall in nO when ρ - n is below a critical level. Thus, such a policychange may limit the flow of North-South knowledge spillovers. When we add imitation µ > 0,numerical simulations imply that a higher σO decreases nO if either µ or ρ - n is below a critical level,
confirming the analytical results. To sum up, our model suggests that technology transfer subsidies
dominate production subsidies when the South’s objective is to increase the extent of production variety
in its borders and realize the associated knowledge spillovers. Given the existence of direct and indirect
subsidies to attract FDI as documented by Hanson (2001), our theoretical model provides practicalguidance to the policy maker who must choose between different policies to generate spillovers. In
practice, the direct policy may take the form of subsidies given to multinationals to assist with
infrastructure, plant set up and education and training of workers, whereas indirect subsidies may involve
corporate tax exemptions and import duty reductions.
Observe that modeling of process innovations provides the key mechanism that generates thecontrasting outcomes between the two subsidies. Higher manufacturing subsidies reduce the incentives ofNorthern entrepreneurs to engage in labor saving in the South. This leads to more employment withineach outsourcing industry, putting downward pressure on the mass of outsourcing industries.

29

5. Conclusion
In this paper, we incorporated what we called the i-pod cycle into the traditional product cycle setting. To
this end, we categorized R&D races into two: outsourcing-targeted- and local-sourcing-targeted.
Entrepreneurs target their eventual location of production by choosing which R&D race to participate in.
R&D involves both product and process innovation. We captured the i-pod cycle in the context ofoutsourcing-targeted R&D races in which participants combine their innovation activities withsimultaneous outsourcing efforts. We used the model to examine the effects of globalization and Southern
FDI policies on wages, R&D intensities and the fraction of Outsourcing industries.
We find that globalization in the form of an improvement in the efficiency of outsourcingtargeted R&D raises the aggregate rate of innovation while reducing the North-South wage gap. We also
identify the compositional effects of globalization on R&D, by finding that the intensity of outsourcingdirected R&D increases whereas the intensity of local-sourcing targeted R&D moves in an ambiguous
direction. These findings imply that the higher frequency of i-pod cycles through increased outsourcingtargeted R&D efforts of Northern entrepreneurs is a robust factor that fosters aggregate innovation.
We argue that from the South’s perspective, technology transfer subsidies can be a more desirable
option vis-à-vis manufacturing subsidies to attract FDI. Manufacturing subsidies directly distort the laborsaving incentives of outsourcing firms and thus lead to more employment within each Outsourcing
industry, which then puts downward pressure on the mass of Outsourcing industries. This adverse effectis more pronounced when the imitation rate and/or discount rate is lower and can lead to a fall in theequilibrium fraction of Outsourcing industries. In addition, the production variety compression in theSouth can have further adverse effects as it reduces the extent of North-South knowledge spillovers.
We have only looked into some aspects of the globalization process. Other aspects such as tariff
reductions are also important and their impacts remain to be analyzed. One might also incorporate
contractual frictions to the product cycle setting along the lines of Antras (2005) and Antras and Helpman(2004), and model the in-house production vs. arm’s length contracting decisions of multinational firms.
In this paper, we have modeled all outsourcing as taking place within the boundaries of the firm or being

30

outsourced to Southern manufacturers in a frictionless contracting environment. Combining our focus ontechnology choices with Antràs’ (2005) contractual frictions is a fruitful undertaking, which we leave forfurther research.

Acknowledgements: We wish to thank S. Das, Y.J. Kim, F. Kimura, C. Lu, seminar participants at Kobe
University, Korea University and the European Trade Study Group annual meetings in Vienna (2006) for
helpful comments. The usual disclaimer applies.

a

FIGURE 1: Steady-State Equilibrium
LHS, RHS

LHS

A

0

RHS

w*

w

ιN
LS

A

ιN*

LN
0

ιO*

ιO

b

FIGURE 2: A Decline in AO
LHS, RHS

LHS′ (AO↓)

LHS

B

RHS

A

0

w*

w

ιN
LS

LS′(AO↓)ιN* increases
iff

A

ιN*

B

LN′(AO↓)
LN

0

ιO*

ιO

ιN
1
>
ιO φ N ( 1 + φO )c

FIGURE 3: An Increase in σO
LHS, RHS

LHS′ (σO ↑)

LHS

B

RHS

A

0

ιN

w*

w

LS′(σO ↑)LS′(σO ↑)if φO > 1 – [1 /(1 + φN)]

if φO < 1 – [1 /(1 + φN)]

ιN* increases
unambiguously

LS

ιN*
0

LN′(σO ↑))
A

LN
ιO*

ιO

d

FIGURE 4: An Increase in σιO
LHS, RHS

LHS′ (σιO ↑)

LHS

B

RHS

A

0

w*

w

ιN
LS

LS′(σιO ↑)ιN* increases
iff

A

ιN*

B

LN′(σιO ↑)
LN

0

ιO*

ιO

ιN
1 + φN>ιO φ N ( 1 + φO )( 1 − σ ιO )i

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