HIAS-E-67

Trade Liberalization, Absorptive Capacity and the Protection ofIntellectual Property Rights
Arghya Ghosh
School of Economics, University of New South Wales, Sydney 2052, Australia

Jota Ishikawa
Faculty of Economics, Hitotsubashi University, Kunitachi, Tokyo 186-8601, Japan

April 2018

Hitotsubashi Institute for Advanced Study, Hitotsubashi University
2-1, Naka, Kunitachi, Tokyo 186-8601, Japan
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http://hias.ad.hit-u.ac.jp/
HIAS discussion papers can be downloaded without charge from:http://hdl.handle.net/10086/27202
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TRADE LIBERALIZATION, ABSORPTIVE CAPACITY AND THE
PROTECTION OF INTELLECTUAL PROPERTY RIGHTS
ARGHYA GHOSH AND JOTA ISHIKAWA

Abstract. We examine how trade liberalization aects South’s incentive to protect
intellectual property rights (IPR) in a North-South duopoly model where a low-cost
North ﬁrm competes with a high-cost South ﬁrm in the South market. The Northﬁrm serves the South market through either exports or foreign direct investment(FDI). The extent of eective cost dierence between North and South depends on
South’s imitation, which in turn depends on South’s IPR protection and absorptive
capacity and North ﬁrm’s location choice, all of which are endogenously determinedin our model. For a given level of IPR protection, South’s absorptive capacity underexports may be greater than under FDI. Even though innovation is exogenous to themodel (and hence unaected by South’s IPR policy), strengthening IPR protection inSouth can improve its welfare. The relationship between trade costs and the degree of
IPR protection that maximizes South welfare is non-monotone. In particular, South
has an incentive to protect IPR only when trade costs are moderate. When masking
technology or licensing is incorporated into the model, however, some protection of
IPR may be optimal for South even if the trade costs are not moderate.
JEL classiﬁcation numbers: F12, F13, D43
Keywords: intellectual property rights (IPR), absorptive capacity, imitation, foreign
direct investment (FDI), licensing, masking, oligopoly, North-South trade model

Date: January 2018.
We are grateful to Bob Staiger, Wolfgang Keller, Steve Yeaple, seminar participants at various universities and conferences including Asia Paciﬁc Trade Seminars (APTS), Australasian Trade Workshop,
European Trade Study Group (ETSG) Meetings, Midwest Trade Meetings, Hitotsubash Conferenceon International Trade and FDI, the Japanese Association for Applied Economics, and the Conferenceof the European Association for Research in Industrial Economics for valuable comments. Ghosh is
grateful for ﬁnancial support from the Australian Research Council. Ishikawa acknowledges ﬁnancial
support from the Japan Society for the Promotion of Science through the Grant-in-Aid for ScientiﬁcResearch (S), Grant Number 26220503.
Ghosh: School of Economics,University of New South Wales, Sydney 2052, Australia, E-mail:a.ghosh@unsw.edu.au; Ishikawa: Faculty of Economics, Hitotsubashi University, Kunitachi, Tokyo
186-8601, Japan, and RIETI, Chiyoda, Tokyo, Japan, E-mail:jota@econ.hit-u.ac.jp.
1

2

ARGHYA GHOSH AND JOTA ISHIKAWA

1. Introduction
Globalization leads to technology transfers/spillovers from developed countries (North)to developing countries (South). A typical channel of technology transfers/spillovers
is trade and foreign direct investment (FDI), which make it easier for South ﬁrms toimitate superior production technologies in North. However, such imitation is neither
automatic nor costless (Grossman and Helpman, 1991; Helpman, 1993; Branstetter and
Saggi, 2011). The extent of imitation depends crucially on South’s absorptive capacity,
i.e., South’s ability to eectively copy the superior technologies of North.
South’s imitation activities are also importantly aected by South government’s
policies and North ﬁrms’ strategic decisions (e.g. location). In particular, imitationis strongly inﬂuenced by the strength of intellectual property rights (IPR) protection
in South. If IPR protection is perfect and fully enforced, patented technologies cannot freely be copied. When IPR protection is imperfect, North ﬁrms may mask theirtechnologies to deter South ﬁrms from copying them unless masking is too costly. Furthermore, North ﬁrm’s location choice aects South’s imitation, because geographicalproximity plays an important role in technology spillovers (see, for example, Eaton andKortum, 1999; Branstetter, 2001; Keller, 2002, and Bilir, 2012). When North ﬁrms
serve the South market, South’s imitation is easier under FDI than under exports.
In this paper, we examine South’s incentive to protect IPR in a North-South duopoly
model where a low-cost North ﬁrm competes with a high-cost South ﬁrm in the Southmarket. The extent of eective cost dierence between North and South speciﬁcallydepends on South’s imitation. As discussed above, imitation depends on North ﬁrm’s
location choice, its masking decision, South’s absorptive capacity (or, absorptive ability) and most importantly South’s IPR protection, all of which are endogenously determined in our framework.
Strengthening IPR protection boosts innovation. While that argument is well understood, critics of stronger IPR regimes in South argue that there is little appreciableeect of IPR protection in South on North innovation (Branstetter and Saggi, 2011).
Furthermore, as argued by Maskus (2000) and Maskus and McDaniel (1999), imposing
a strong IPR regime might retard industrial development of the developing countries.
Taking these arguments seriously, we assume that North innovation, which is presumably the source of North’s cost advantage, is exogenously given. Instead, we incorporate North ﬁrm’s other decisions (e.g., location choice and masking behavior) into ourmodel and show that incorporating these features and endogenizing South ﬁrm’s imitation eorts to establish absorptive capacity have important IPR policy implicationsfor South. In particular, we show that South can beneﬁt from strengthening its own
IPR protection even when North innovation is unaected by its IPR policy.
To make our analysis tractable, we assume that the trade liberalization is caused
by a decrease in trade costs, which is beyond the control of the South government.

TRADE, ABSORPTIVE CAPACITY AND IPR

3That is, trade costs are declining as the result of a decrease in transport costs and apre-commitment to the reduction of trade barriers. Hence, the policy instrument theSouth government can freely set is only the degree of IPR protection. We ﬁnd that therelationship between trade costs and South’s incentive to protect IPR can be subtle.
In particular, we show that trade liberalization can mute or amplify the North-Southconﬂict regarding IPR protection, depending on the trade costs.
To understand our implications better, we present more details of our North-Southduopoly model. A North ﬁrm (ﬁrm N), in our framework, has zero cost of production
while a South ﬁrm (ﬁrm S) starts with unit cost c(> 0). Given trade costs, the South
government chooses the level of IPR protection k 5 [0, 1] where k = 0 implies full
protection of IPR while k = 1 implies no protection of IPR. The strength of IPR
protection declines as k increases. Following South government’s choice of k, ﬁrm N
decides whether to export to South market or serve it via FDI. If ﬁrm N opts to export
to South market, it incurs a trade cost of t per unit. After the ﬁrm N’s decision has
been made, ﬁrm S chooses the level of imitation eorts, i.e., the level of investment
C(z) in absorptive capacity which reduces its unit cost from c to c(1  kz) (wherez 5 [0, 1]). As imitation is easier with FDI, we assume that C(z) is lower under FDI.
Given that Cournot analysis is standard, let us start with the exports versus FDI
decision. If ﬁrm N chooses FDI, it avoids per unit trade cost. However, FDI makes
the absorption of new technology easier for ﬁrm S, which can partially erode North’s
cost advantage. When IPR protection is weak, the erosion of North’s cost advantage
is higher. This trade-o between trade cost savings and reduction in cost-advantage is
key to the location choice decision by ﬁrm N.1
The second and probably more important component of our analysis is the endogenous determination of South’s absorptive capacity. If South’s absorptive capacity islow, then South’s IPR protection policy has little eect. While part of a ﬁrm’s absorptive capacity can be viewed as its innate ability to absorb new technology–and
hence can be treated as exogenous–presumably, the capacity could be changed via
investment, i.e., imitation eorts.
By locating in South, FDI makes imitation easier for ﬁrm S, which encourages investment in absorptive capacity. However, as ﬁrm N saves per unit trade cost, its eective
unit cost of production declines with FDI. This reduces ﬁrm S’s output and consequently its incentive to invest in absorptive capacity. We ﬁnd that absorptive capacity
and consequently productivity spillovers–eective cost reduction in our framework–
could be higher or lower with FDI. Such ambiguity only arises when absorptive capacity
is endogenously determined.
1In addition to trade cost savings, North ﬁrm can also enjoy other forms of cost advantage, e.g., low

input cost in South, which might make FDI even more attractive for North. Incorporating other formsof cost advantage will not alter our analysis as long as the magnitudes of these cost-advantages are
exogenously given.

4

ARGHYA GHOSH AND JOTA ISHIKAWA

The ambiguity might seem surprising as it is often thought that FDI beneﬁts Souththrough technology and knowledge spillovers to the local rivals (Keller, 2004). See, forexample, Dimelis and Louri (2002), Gri!th, Redding and van Reenen (2003), Javorcik(2004), Chakraborty and Nunnekamp (2008) and Suyanto, Salim and Bloch (2009) for
evidence on positive productivity spillovers. On the other hand, Aitken and Harrison (1999), Djankov and Hoekman (2000), and Barry, Gorg and Strobl (2005) founda negative relationship between FDI and spillovers. By endogenizing investment inabsorptive capacity, our theoretical analysis oers an explanation for the ambiguous
relationship.
Finally, we turn to IPR protection. Recall that ﬁrm N’s unit cost is exogenously
given and not aected by South’s IPR policy. As South strengthens its IPR protection,
South’s marginal cost increases which in turn reduces proﬁts and consumer surplus forSouth. Thus, strengthening IPR protection might seem to reduce South’s welfare.
Indeed, if location choice or masking behavior is not an issue, this argument holds.
For example, if trade costs are prohibitive with location choice, ﬁrm N has no choice
but to opt for FDI. In this case, it is optimal for South to oer no protection for
IPR. However, if trade costs are not prohibitive, ﬁrm N’s losses under FDI from highspillovers (induced by weak IPR) might outweigh the gains from saving trade costs.
Thus, weak IPR might lead ﬁrm N to opt for exports. If ﬁrm N chooses exports,
it might be bad for South as well. As ﬁrm N incurs trade costs under exports, theequilibrium price is higher, which hurts consumers. This negative eect is reinforced
if investment in absorptive capacity is lower under exports. We ﬁnd that indeed, for arange of parameterizations, it is in South’s interest to strengthen IPR protection justenough that ﬁrm N opts for FDI.
Interestingly, we ﬁnd a non-monotone relationship between trade costs and the levelof IPR protection that maximizes South’s welfare in the presence of location choice. If
the trade cost is too high, IPR protection (to induce FDI) is not necessary, since in thatcase the North ﬁrm opts for FDI anyway. If the trade cost is too low, strengthening IPR
protection does not improve welfare, either. Strengthening IPR protection improves
South’s welfare only for moderate values of trade costs.
In section 3, we show that strengthening IPR protection can induce ﬁrm N to choose
FDI over exports, which in turn improves South’s welfare. However, this is not the
only channel through which IPR can improve welfare. In section 4, we abstract awayfrom location choice decision (by assuming that there are no trade costs) and focus on
masking decision because North ﬁrms often undertake a variety of costly activities toprevent the imitation of its technology (see section 4 for details). To capture costly
masking, we consider a model where ﬁrm N’s eective unit cost is m if it masks its
technology and zero otherwise. Masking increases the cost of investment in absorptive
capacity for ﬁrm S.

TRADE, ABSORPTIVE CAPACITY AND IPR

5In terms of eects, we ﬁnd that masking is similar to exports, while non-masking issimilar to FDI. Firm N engages in masking if and only if IPR protection in South isnot su!ciently strong. In this setup we show that strengthening IPR protection can
improve South’s welfare by deterring ﬁrm N from masking its technology. As in thecase of trade costs, we ﬁnd that protection is optimal only for intermediate values ofm. Irrespective of the strength of IPR protection, ﬁrm N masks its technology whenm is low and does not mask when m is high. In the intermediate range of values of m
however, strengthening IPR protection deters masking and improves South’s welfare.
In our model, FDI facilitates imitation which in turn reduces the production cost ofﬁrm S. However, anticipating imitation, ﬁrm N might license and transfer its technology to ﬁrm S. Incorporating licensing in our model, and assuming away location
choice, we ﬁnd that strengthening IPR protection can improve South’s welfare in arange of parameterizations. In particular, we ﬁnd that IPR protection can improve
South welfare when the dierence in the unit costs between ﬁrm N and ﬁrm S is not
too high or not too low. If the cost dierence is too low, ﬁrm N will always license
its technology to ﬁrm S. If the cost dierence is too high, ﬁrm N will never license
its technology irrespective of the the strength of IPR protection. For moderate dierences in costs, IPR protection plays an important role. Strengthening IPR protection
improves South welfare, because it induces ﬁrm N to license its technology to ﬁrm S.
This result is consistent with empirical ﬁndings (for example, see Branstetter, Fisman
and Foley, 2006; and Kanwar, 2012).
The plan of the paper is as follows. Section 2 describes the relationship between our
analysis and previous IPR literature. Section 3 explores the four-stage game with Northﬁrm’s location choice. We ﬁnd the optimal IPR policy from South’s perspective, taking
into account the impact of the degree of IPR protection on absorptive capacity andlocation choice. Section 4 investigates a three-stage game with North ﬁrm’s masking
behavior instead of location choice. Section 5 compares licensing with FDI. Section 6oers concluding remarks.
2. Relation to Previous Literature
In this section, we brieﬂy relate the present study to previous North-South trade
literature from the viewpoint of IPR protection.2 Helpman (1993) provided the ﬁrst
general equilibrium analysis of IPR policy in a North-South product cycle model with
innovation, imitation and growth. The early works in this area (Helpman,1993; Glassand Saggi, 2002) ﬁnd that strengthening IPR protection in South reduces South welfare
and may or may not beneﬁt North. Lai (1998) argues that if FDI is the channel of
2A number of studies deal with choice among modes to serve foreign markets without taking IPR into

account. Examples include Horstmann and Markusen (1987), Ethier and Markusen (1996) and Saggi(1996). Saggi (2002) surveys the literature.

6

ARGHYA GHOSH AND JOTA ISHIKAWA

technology transfer from North to South implying imitation occurs only under FDI,
the conclusion no longer holds.
Branstetter and Saggi (2011) push this literature based on North-South product cycle
models further by making both imitation and FDI endogenous. Branstetter, Fisman,
Foley and Saggi (2011) show that while the imitation activities decline in South withthe strengthening of its IPR regime, the expansion of multinational activity can morethan oset the decline. Examining the responses of U.S.-based multinationals anddomestic production to a set of IPR reforms in the 1980s and 1990s, they conﬁrm thatis indeed the case. Most papers in this literature evaluate the welfare consequence ofmarginal changes in imitation to analyze the impact of IPR protection. An exception is
the paper by Grossman and Lai (2004). They explicitly consider both (i) simultaneous
choice of IPR protection by trade partners and (ii) a globally e!cient regime of IPR
protection in a multi-country, trading world where countries dier in their size andinnovation capacities.
Despite oering valuable and rich insights, these dynamic North-South general equilibrium models often do not involve strategic interaction among ﬁrms, which is often a
key component of analysis in the oligopolistic markets (Yang and Maskus, 2009). For
detailed microeconomic analysis of ﬁrm and government behavior, we adopt a partial
equilibrium, Cournot duopoly framework. This allows us to capture crucial ﬁrm level
decisions such as where to locate or how much to invest, in a detailed fashion.
In a simple North-South duopoly model with Cournot competition, Chin and Grossman (1990) showed that no protection of IPR is better than the full protection of IPR
for South’s welfare. Examining the welfare eects of the geographical scope of patent
coverage, Deardor (1992) reports similar results. Both Chin and Grossman (1990) and
Deardor (1992) consider binary choice regarding protection of IPR: full protection or
no protection. Allowing for various degrees of IPR protection as well as for dierencesin preference and technology, Diwan and Rodrik (1991) show that South might beneﬁt
from protection of IPR if the dierences in preferences are substantial. Introducing
R&D with spillovers into a North-South duopoly model, Žigić (1998, 2000) shows thatthe result obtained in Chin and Grossman (1990) is no longer robust. He speciﬁcallyregards the intensity of spillover as an indicator of the strength of the IPR protection.
He assumes that if North ﬁrm’s cost-reducing R&D decreases its own marginal cost
(MC) by 1, then it also lowers South’s MC by k 5 [0, 1], which is an indicator of thestrength of the IPR protection.
Recent empirical evidence shows that the presence of foreign ﬁrms does not automatically lead to technology spillovers, however. Rather, it depends importantly
on local ﬁrms’ investment in R&D related activities (Kathuria, 2000; Gri!th, Redding
and van Reenen, 2003; Suyanto, Salim and Bloch, 2009). Naghavi (2007) extends Žigić
(1998) by considering the possibility of FDI and decomposing the intensity of spillovers
into the strength of the IPR protection and the extent of absorptive capacity just like

TRADE, ABSORPTIVE CAPACITY AND IPR

7kz in our model. Naghavi (2007) shows that South can always gain from enforcing
stringent IPR protection, either by attracting FDI in less R&D-intensive sectors or bystimulating innovation in high-technology sectors. Yang and Maskus (2009) also haveabsorptive capacity in their work. They focus on a scenario in which the North ﬁrmchooses either exports or technology transfer through licensing. They show that byencouraging technology transfer, South’s stronger IPR protection might improve theability of South ﬁrms to break into export markets and that South’s welfare depends
on its absorptive capacity.
The key dierence between our work and existing works in partial equilibrium based
IPR literature in general, and Žigić(1998), Naghavi (2007) and Yang and Maskus(2009) in particular, is that we treat absorptive capacity as endogenous by explicitly
modelling South ﬁrm’s imitation eorts to obtain absorptive capacity. The endogeneity
is important in our framework for two reasons. If the absorptive capacity is exogenous
and the same under FDI and exports in our model, both the location choice decision
for North and the optimal IPR policy become trivial: North always chooses FDI andSouth oers no protection of IPR.3 Alternatively, appealing to common wisdom, one
can assume that absorptive capacity is higher under FDI than exports. However, thatwould not be innocuous as we have discussed earlier (and formally demonstrate in
Proposition 2), that the absorptive capacity under FDI could be higher or lower thanthat under exports.
Grünfeld (2006) also explicitly models the concept of absorptive capacity in an international duopoly model. In his framework, both domestic and foreign ﬁrms engage
in cost-reducing R&D, which also determines the R&D spillover rate. Except for theendogenous determination of absorptive capacity, however, there is little similarity between his work and ours. We are concerned with South’s incentive to protect IPR in
the process of trade liberalization, which is absent in Grünfeld (2006). Moreover, since
he assumes two-way spillovers, his model is better suited to analyzing spillovers between developed countries. In contrast, we deal with one-way spillovers from North toSouth, which seems more appropriate for analyzing South’s imitation of North. Also,
the masking behavior of North ﬁrms is not explicitly considered in Grünfeld (2006).
Taylor (1993) explicitly incorporates North’s masking eorts and South’s reverse
engineering eorts in a North-South duopoly model to examine the relationship between
the IPR protection in South and technology transfers. Our model is related to Taylor’s
work as we also endogenize South’s imitation eorts, and North’s masking decision.
However, in contrast to Taylor(1993), where masking is modelled as an increase inﬁxed costs for the North ﬁrm, we assume that masking increases the variable cost for3In a dierent context, Ishikawa and Horiuchi (2012) investigate ﬁrm’s strategic location choice in thepresence of technology spillovers with exogenous absorptive capacity. However, IPR is absent fromtheir analysis.

8

ARGHYA GHOSH AND JOTA ISHIKAWA

the North ﬁrm.4 An important implication of our speciﬁcation is that as the North ﬁrm
switches from non-masking to masking, the South ﬁrm can increase its imitation eorts.
Also, as masking is a binary decision in our framework –see section 4 for details–
strengthening of IPR protection in South can deter North ﬁrms from masking but it
does not necessarily do so. Strengthening IPR protection deters masking and improves
South’s welfare only if the cost of masking is not too high or too low. Note that masking
per se is not the main focus of our paper. In fact, as we show in section 3, a case forstrengthening IPR protection in South exists when location (rather than masking) is
the key decision variable for the North ﬁrm. In section 4, we simply show that such amodel with endogenous location choice could be translated to a model with endogenous
masking decision without much substantive change.
Earlier papers in the literature on trade and licensing assume that licensing is costless, that is, licensing does not involve resource costs. Examples include Kabiraj andMarjit (1993, 2003), Mukherjee and Pennings (2006), Ishikawa (2007), and Horiuchi
and Ishikawa (2009). These studies are primarily concerned with how government can
induce technology transfers through subsidies or taris in the presence of strategic useof licensing. The interaction between IPR protection and licensing is not examined.
The role of IPR in the context of trade and licensing is discussed in Yang and Maskus(2009). Introducing costly licensing in an oligopoly framework, they convincingly argue
that strengthening IPR protection can beneﬁt South by reducing the costs of technology transfer. In contrast, in our analysis, licensing induced by stronger IPR protection
beneﬁts consumers and hence South gains.
3. Model with Location Choice
3.1. Setup. There are two countries, North and South, each with one ﬁrm denotedby ﬁrm N and ﬁrm S respectively. These ﬁrms sell a homogenous product in theSouth. As we are primarily interested in the incentives and welfare consequences ofstrengthening IPR protection in South, we assume that all consumers are located inSouth. The inverse demand for the product in the South is
P = bQ(1)= b  (qN + qS ),where qi (i = N, S), Q  qN + qS and P respectively denote output of ﬁrm i, aggregate
output and market price.
4Whether masking is better modeled as an increase in ﬁxed cost (as in Taylor, 1993) or an increase in

marginal cost (like ours) depends on the context. Consider for example the list of masking activities
mentioned in Taylor (1993): software programming traps, copy-protect schemes, the encryption ofimportant codes, maintaining a vigilant legal department, and monitoring the imports of similar
foreign products. While the last two activities can be captured via an increase in ﬁxed costs, theothers may ﬁt well with an increase in marginal cost.

TRADE, ABSORPTIVE CAPACITY AND IPR

9Firm N’s marginal cost of production is assumed to be zero. Firm N can either
locate in North and export to South, incurring a trade cost of t > 0 per unit of qN .
Otherwise, it can opt for FDI in South. That is, ﬁrm N can build a plant in South andserve the South market from that plant. In that case, ﬁrm N does not incur the trade
costs. For simplicity, we assume that there are no ﬁxed costs for setting up a plant inSouth.5
Firm S is located in South. The initial unit cost of production for ﬁrm S is a constantc > 0. However, the eective unit cost for ﬁrm S is(2)

cS = c(1  kz);

k 5 [0, 1],z 5 [0, 1],

where z denotes the absorptive capacity (or, the imitation ability) of ﬁrm S and k
captures the degree of IPR protection in South. If k = 0, intellectual property rights
are fully protected while if k = 1, there is no protection of IPR. As k increases fromzero to unity the protection becomes weaker. Weakening of the IPR protection inSouth reduces the cost advantage of ﬁrm N. However, even with no IPR protection(i.e., k = 1) ﬁrm N enjoys some cost advantage as long as z < 1.
Firm S has to make an eort to develop absorptive capacity. To attain the capacity
level z, ﬁrm S has to incur costs, C(z). In the following, we refer to this eort asinvestment in absorptive capacity. We assume that C(0) = 0, C 0 (z) > 0 and C 00 (z) > 0
for all z > 0. Furthermore, to obtain closed-form solutions, we consider C(z) = kz 2 ,where k = kE if ﬁrm N opts for exports and k = k F if ﬁrm N opts for FDI.
We assume that kE > kF . Several authors including Eaton and Kortum (1999),
Branstetter (2001), and Keller (2002) among others have pointed out that proximity
facilitates imitation. In other words, absorption is easier when ﬁrms are geographicallycloser to each other. This might be due to the possibility of worker mobility betweenﬁrms N and S or other mechanisms (e.g., both ﬁrms buying local inputs from a common
supplier).6
The timing of the events is as follows.
Stage 1 [Exports or FDI]: Given k– which we assume to be exogenous until subsection 3.5 – ﬁrm N decides whether to serve the South market via exports or FDI.
Let e denote the binary variable capturing the ﬁrm N’s mode of serving the Southmarket where(
1, if ﬁrm N exports to South;e=0, if ﬁrm N serves South by FDI.
5To be precise, the cost of building a ﬁrst plant in South is zero, while the cost of building a second

plant is prohibitive. Thus, eectively, the number of North plants in South is either zero or one.
6For some products, it is possible that kE = kF , e.g., if reverse-engineering is equally eective irre-

spective of the location of the North ﬁrm. We ignore this special case since then the North ﬁrm would
always choose FDI in our framework.

10

ARGHYA GHOSH AND JOTA ISHIKAWA

Stage 2 [Investment in absorptive capacity]: Given k and e, ﬁrm S chooses thelevel of absorptive capacity z.
Stage 3 [Cournot competition]: Given k, e, and z, each ﬁrm i chooses qi to maximize its proﬁts taking the rival ﬁrm’s output, qj , as given (i, j 5 {N, S}, i 6= j).
A few remarks are in order regarding the assumptions of the model. First, theassumption that ﬁrm N’s marginal cost is zero is innocuous. Second, the fact that
there are no ﬁxed costs for FDI simpliﬁes the algebra but is not crucial for our results.
Introducing a strictly positive plant-speciﬁc ﬁxed cost would make FDI less preferable
to exports. Third, we have implicitly assumed that the North and South markets aresegmented and that ﬁrm S does not sell in North. Introducing the possibility thatﬁrm S exports to North does not qualitatively change our ﬁndings unless the North
government sets policy strategically. Finally, our cost speciﬁcations, i.e. cS = c(1  kz)
and C(z) = kz 2 , suggest that unless ﬁrm S invests in absorptive capacity, the costdierence between ﬁrms N and S stays at c. An alternative speciﬁcation could be
cS = c(z0 )(1  kz) where 0 < c(z0 ) < c = c(0) holds for all z0 > 0. The term z0
could be interpreted as the innate imitation ability of ﬁrm S. We chose to work withc(z0 ) = c because this greatly simpliﬁes the algebra.
Now we turn to characterizing the unique Subgame Perfect Nash Equilibrium (SPNE)
of the game. To facilitate this characterization, we make a number of simplifying assumptions regarding the upper and lower bounds of dierent parameters:
2

Assumption 1: (i) c < 2b , (ii) t < 2b , and (iii) kF > b9 .
Assumption 1 implies that the initial marginal cost of ﬁrm S is such that it produces
a strictly positive amount of output for all (k, e, z) satisfying k 5 [0, 1], e 5 {0, 1} andz 5 [0, 1]. The bound for t in Assumption 1(ii) ensures that ﬁrm N sells a strictly
positive amount in South even when it chooses to export. Assumption 1(iii) ensuresthat the second-order condition of the stage 2 optimization problem is satisﬁed andthe equilibrium value of z is strictly interior (i.e. lies between zero and unity).
3.2. Cournot equilibrium. First consider the stage 3 game where the two ﬁrms
compete in quantities. Prior to this stage, the degree of IPR protection in South(k),North ﬁrm’s mode of entry (e) and South ﬁrm’s absorptive capacity (z) have beenchosen. So, both ﬁrms S and N take these variables as given.
For a given (k, e, z), ﬁrm S chooses qS to maximize (b  qN  qS  c(1  k)z)qN while
ﬁrm N chooses qN to maximize (b  qN  qS  et)qN . Routine computation yields:(3)q̃N (k, e, z) =b  2et + c(1  kz)b  2c(1  kz) + et
, q̃S (k, e, z) =,3
3

TRADE, ABSORPTIVE CAPACITY AND IPR(4)

Q̃(k, e, z)  q̃N (k, e, z) + q̃S (k, e, z) =11

2b  et  c(1  kz),
3(b  2et + c(1  kz))2(b  2c(1  kz) + et)2
, Z̃ S (k, e, z) =,99where q̃i (k, e, z), and Z̃ i (k, e, z) denote the quantity and proﬁts of ﬁrm i(= N, S) in
the Cournot equilibrium. The following lemma records comparative statics results for
future reference.
(5)

Z̃ N (k, e, z) =Lemma 1. For any given location choice (i.e., e = 0, or e = 1),(i) q̃N (k, e, z) and Z̃ N (k, e, z) are decreasing in k and z.
(ii) q̃S (k, e, z) and Z̃ S (k, e, z) are increasing in k and z.
(iii)Q̃(k, e, z) is increasing in k and z.
Both the weakening of IPR protection (i.e., an increase in k) and an increase inabsorptive capacity (i.e., an increase in z) reduces the unit cost of ﬁrm S. This inturn increases ﬁrm S’s output and proﬁts. Firm N’s output and proﬁts decline sinceq̃S (k, e, z) and q̃N (k, e, z) are strategic substitutes. Part (iii) is a standard result from
Cournot competition: aggregate output increases as unit cost declines (through anincrease in k or z in this case).
3.3. Absorptive Capacity. Consider stage 2 where ﬁrm S chooses the level of absorptive capacity z. For a given degree of IPR protection, k, and ﬁrm N’s location
choice, e, ﬁrm S chooses z to maximize
Z̃ S (k, e, z)  k(e)z 2  Z S (k, e, z),where k(e)  ekE + (1  e)kF . The marginal cost of investment in z is
2k(e)z,while the marginal beneﬁt from investment in absorptive capacity, given by Y Z̃S (k,e,z)Yzis:
2kc(b  2c(1  kz) + et)
Y Z̃ S (k, e, z)
Y q̃S (k, e, z)= 2q̃S (k, e, z)
=
.
(6)
Yz
Yz
9
Equating marginal cost with the marginal beneﬁt of investment in z gives South ﬁrm’s
absorptive capacity in stage 2 equilibrium:(7)z=

2kc(b  2c + et) z(k, e)9k(e)  4k2 c2

where k 5 [0, 1] and e 5 {0, 1}. The following proposition follows immediately fromthe expression of z(k, e).
PROPOSITION 1. Absorptive capacity, given by z(k, e),(i) increases as the degree of IPR protection weakens;

12

ARGHYA GHOSH AND JOTA ISHIKAWA(ii) decreases as (a) the cost of investment (k(e)) rises, and (b) the trade cost (t) falls.

To understand Proposition 1, recall the eective cost of production for ﬁrm S: cS =c(1  kz). As z increases, cS declines, which raises ﬁrm S’s proﬁts. The weaker the
IPR protection, the larger is the decline in cS and consequently the larger the increase
in ﬁrm S’s stage 3 proﬁts. This logic, together with the fact that marginal cost ofinvestment, k(e)z, is independent of the degree of IPR protection imply Proposition
1(i).
The relationship between the cost of investment, k(e), and absorptive capacity isstraightforward. Concerning trade costs, note that z(k, 0) is independent of t. Thus
trade cost t matters only if ﬁrm N exports. As the trade cost falls, ﬁrm N’s eective
unit cost declines. It produces more, and since quantities are strategic substitutes,
ﬁrm S produces less. A reduction in q̃S (k, 1, z) lowers South’s marginal beneﬁt frominvestment in absorptive capacity which in turn reduces z(k, 1).
Let z F (z E ) denote the equilibrium absorptive capacity of ﬁrm S when ﬁrm N chooses
FDI (exports). Using (7) we get:(8)z F  z(k, 0) =(9)z E  z(k, 1) =2kc(b  2c),
9kF  4k2 c2

2kc(b  2c + t).
9kE  4k2 c2

Deﬁne qiF  q̃i (k, 0, z F ), ZFi  Z̃i (k, 0, z F ) and QF  Q̃(k, 0, z F ) where qiF , Z Fi and
QF respectively denote ﬁrm i’s quantity, ﬁrm i’s proﬁts and aggregate output in stage
2 equilibrium when the North ﬁrm opts for FDI in stage 1. Similarly qiE  q̃i (k, 1, z E ),E
E
E
ZEi  Z̃ i (k, 1, z ) and Q  Q̃(k, 1, z ) respectively are ﬁrm i’s output, ﬁrm i’s proﬁts
and aggregate output in stage 2 equilibrium when the North ﬁrm chooses to exports instage 1. Using Lemma 1 and Proposition 1, we can establish the following relationships
between the equilibrium outcomes in stage 2 and the strength of IPR protection.
Lemma 2. North ﬁrm’s proﬁts decline while South ﬁrm’s proﬁts and aggregate output
increase as the strength of IPR weakens in South. These results hold for both modes ofNorth entry into the South market– exports as well as FDI. More formally,(i) Z FN and ZE
N are decreasing in k.
(ii) Z FS and Z E
S are increasing in k.
E(iii)Q and QF are increasing in k.
As the strength of IPR protection weakens, South ﬁrm’s investment in absorptive
capacity increases. The eective unit cost of production for South, cS  c(1  kz),
declines. Part (i) follows from the logic that lower cS leads to higher qS , which in turn

TRADE, ABSORPTIVE CAPACITY AND IPR

13implies lower qN and consequently lower Z N . To understand part (ii), writedZ S
YZ S YZ S dz
=
+
dk
Yk
Yz dk
S
S
= 0 (envelope theorem) and YZ> 0 (Lemma 1). Part (iii) is
and observe that YZ
Yz
Ykeasy to understand once we recognize that in a Cournot setup the aggregate output
increases as the unit cost declines.

Now we turn to the comparison between z F and z E . If IPR protection is perfect, i.e.,k = 0, there is no incentive to invest in absorptive capacity and hence z F = z E = 0.
However, with imperfect IPR protection (i.e., k > 0), absorptive capacity could belower or higher under FDI. Using (8) and (9) we getzF  zE =which implies(10)

2kc(b  2c)t(9kF  4k2 c2 )
E
F
(9(k
)

k
)

(9kE  4k2 c2 )(9kF  4k2 c2 )b  2czF T zE / t S

9(kE  kF )(b  2c).
9kF  4k2 c2That z F could be lower than z E might sound surprising, since the marginal cost ofinvestment in absorptive capacity is lower under FDI. However, the marginal beneﬁt
from investment in z under FDI is smaller as well:Y Z̃ S (k, 0, z) Y Z̃ S (k, 1, z)
2kct

=
< 0.
Yz
Yz
9
To understand why, note that ﬁrm N’s unit cost of production is lower under FDI
because it saves trade cost t per unit. The reduction in ﬁrm N’s unit cost leads tohigher qN and lower qS which in turn reduces ﬁrm S’s incentive to invest in z. As
both marginal beneﬁt and marginal cost of investment in absorptive capacity are lower
under FDI, z F could be higher or lower than z E . Using (10), Proposition 2 gives amore precise characterization.
PROPOSITION 2. For any given degree of IPR protection, absorptive capacity
is strictly higher under FDI than under exports if and only if trade costs are su!ciently low. More formally, for all k 5 [0, 1], there exists a threshold value t̃(k) EF )(b32c)min{ 9(k9k3k, 2b } such that z F > z E holds if and only if t < t̃(k). Furthermore,
F 34k2 c2t̃(k) is weakly increasing in k.
To understand the logic behind Proposition 2, consider the extreme case, t = 0. As
there is no trade cost saving from FDI, North ﬁrm’s output in the Cournot equilibriumis the same under FDI and exports for a given z, as is South ﬁrm’s output. This in turnimplies that South ﬁrm’s marginal beneﬁt from investment in absorptive capacity is
the same under FDI and exports. Since the marginal cost of investment is strictly lower
under FDI, it follows that z F > z E . By standard continuity argument, it follows that

14

ARGHYA GHOSH AND JOTA ISHIKAWAz F > z E holds if the trade costs are su!ciently low. Now consider the other extreme
when t is almost prohibitive. For exogenously given z, South’s Cournot output is higher
under exports which implies that the marginal beneﬁt of investment in absorptive
capacity is higher under exports. If k E  k F , the marginal cost of investment is similar
under FDI and exports, and consequently z E > z F holds. Once again, by continuity
argument, it follows that z F < z E holds if the trade costs are su!ciently high.
We conclude this subsection by presenting a non-monotonicity result.

PROPOSITION 3. (i) Absorptive capacity under FDI, z F , is inverted U-shaped inﬁrm S’s initial unit cost of production c. For all k 5 (0, 1] there exists cF (k) > 0 such
that
dz F
T 0 / c S cF (k).
dc
The absorptive capacity under exports, z E , displays similar non-monotonicity with reE 3k2 b2 )spect to c as long as t < min{ b(9k, 2b }.
9kE +k2 b2(ii) A higher initial unit cost of production does not necessarily imply a higher eective
unit cost. More formally, there exist values of c, namely c1 and c2 such that c1 > c2 andyet c1S  c1 (1  kz 1 ) < c2 (1  kz 2 )  c2S where z 1 and z 2 denote absorptive capacities
in stage 2 equilibrium corresponding to initial unit costs c1 and c2 respectively.
The logic underlying Proposition 3(i) is as follows. Consider the FDI case andsuppose c  0. The cost dierence is very small to start with, and the incremental
change in output due to additional investment in z is negligible. If the cost dierenceis large, limc< b q̃S (k, 0, z) = 0 which in turn implies limc< b Y Z̃S (k,0,z)= 0. Thus, forYz
22both extremes – cost dierence that is too large or too small – the beneﬁt from anadditional unit of investment in z is negligible and consequently z  0. For intermediate
values of c however Y Z̃S (k,0,z)
is strictly positive, which generates the non-monotonicity.
Yz
Unless the trade cost is large, the same logic works when ﬁrm N opts to export.
To understand part (ii), note that, for c > cF (k), investment in absorptive capacity
decreases as c increases. Hence, higher c does imply higher cS . However, for c < cF (k),absorptive capacity declines as c declines. Thus lower initial marginal cost does notnecessarily translate to lower eective marginal cost once investment in absorptive
capacity is taken into account. In the Appendix, we show that there are indeed parameterizations under which this occurs. Sawada (2010) ﬁnds a similar result in a
North-South duopoly model where both North and South ﬁrms put eort into reducing its cost. However, IPR protection and location choice, which play an importantrole in the remainder of this paper, are absent from Sawada (2010).
The ﬁnding has an important implication. Suppose there are two South countries,
S1 and S2 which do not trade with each other. Also, assume that the initial marginal
cost is lower in S1 . Despite having an initial cost advantage, ﬁrm S1 might end up with

TRADE, ABSORPTIVE CAPACITY AND IPR

15

a higher marginal cost, following FDI by a North ﬁrm (in both South countries) andthe investment in absorptive capacity.
3.4. Exports versus FDI. FDI lowers ﬁrm N’s eective unit cost by saving per unit
trade cost t. However, under FDI, ﬁrm S’s unit cost cS  c(1  kz) might be lower
if z F > z E . So, when does ﬁrm N choose to export (e = 1) and when does it choose
FDI (e = 0)? Assume that in the case of indierence between exports and FDI, ﬁrm
N opts for FDI. Firm N opts for FDI in SPNE if and only if Z FN  Z E
N  0. We havethat
F
E
Z FN  ZE
N  0 / qN  qN  0(11)/ kc(z F  z E )  2t  0.

F 2
E 2
where the ﬁrst / follows from using that Z FN = (qN) , ZEN = (qN ) , and the second /FEfollows from substituting the expression for qN
 q̃N (k, 0, z F ) and qN
 q̃N (k, 0, z E ) in
(11).
First, consider the case k = 0. IPR protection is perfect which implies z F = z E = 0.
Firm N chooses FDI for all t > 0 since kc(z F  z E )  2t = 2t < 0. In the case of
perfect IPR protection, ﬁrm N’s only consideration (while making location choice) is
trade costs. By choosing FDI, ﬁrm N avoids trade costs and hence it prefers FDI toexports.
Now consider the case t = 0. From (8) and (9) we know that z F  z E > 0 which
implies that kc(z F  z E )  2t > 0. In the case of zero trade costs, ﬁrm N’s unit costis the same no matter where it locates, but ﬁrm S’s unit cost cS  c(1  kz) is higher
if ﬁrm N chooses to export. Thus ﬁrm N’s optimal choice is to locate in North andexport to South.
The discussion above casts the trade-o involved in ﬁrm N’s location choice in termsof trade costs and absorptive capacity. However, note that, absorptive capacity is an
endogenous variable. The equilibrium value of absorptive capacity depends on trade
cost parameter, t, and the degree of IPR protection, k – see (8) and (9). Substituting
the expression for z F and z E from (8) and (9) in (11) above and analyzing the inequality
further gives the following proposition.

PROPOSITION 4. The North ﬁrm prefers FDI to exports if IPR protection isstrong enough. The minimum degree of IPR protection that induces FDI increases
as trade costs decline. More formally, for all t > 0, there exists k(t) 5 [0, 1] suchthat ﬁrm N opts for FDI in stage 1 if and only if k  k(t). There exists t̄ 
9c2 (kE 3kF )(b32c)bmin{ (9kF 34c2 )(9kE 33c2 ) , 2 } such that k(0) = 0, k(t) < 1 for t < t̄ and k(t) = 1 fort  t̄. Furthermore, k(t) is continuous (in t) and k0 (t) > (=)0 for all t < (>)t̄.
Proposition 4 says how the exports versus FDI decision of ﬁrm N depends on trade
9c2 (kE 3kF )(b32c)
costs and the strength of IPR protection in South. Assume that t̄ = (9kF 34c2 )(9kE 33c2 ) .

16

ARGHYA GHOSH AND JOTA ISHIKAWA

In that case, according to Proposition 4, the North ﬁrm locates in South for all t 5 (t̄, 2b )even if there is no protection of IPR in South. This ﬁnding reﬂects the tari-jumping
motive of FDI, except that we use trade costs instead of taris. To ensure that motive
dominates–at least for the high values of trade costs–we assume that the following
condition holds for the remainder of section 3:7
2
b2+ kE .
(12)
kF >
27 3
As ﬁrm N might locate in South even if there is no protection of IPR (i.e., k = 1),
it might seem that endogenous absorptive capacity and consequently the strength of
IPR protection has little role to play. However, note that if absorptive capacity were
exogenous and the same under FDI and exports (i.e., z = z F = z E ), (11) implies thatﬁrm N would prefer FDI for all t > 0 and not just high t. This observation highlights
the importance of endogenous absorptive capacity in ﬁrm N’s choice between FDI
versus exports.
The second part of the Proposition unravels a complementary relationship between
trade liberalization and South’s IPR protection. As trade costs decline, the option ofexports becomes more attractive to North. This implies that the critical level of IPR
protection needs to be stronger in South so that the North ﬁrm prefers FDI to exports.
As we show below, the impact of IPR protection on North ﬁrm’s location decision plays
an important role in determining the optimal IPR policy for South.
3.5. Intellectual Property Rights (IPR). Consider an extended game where inStage 0, prior to location choice of ﬁrm N, the South government chooses k to maximize
South welfare. Would it ever choose k 5 (0, 1)? In other words, would South welfare
ever be higher with some protection of IPR?8South welfare (W ) is the sum of consumer surplus (CS) and South ﬁrm’s proﬁts(Z S ). Corresponding to the demand function P = b  Q, consumer surplus (CS) is
Q2 /2. Let CS F (k) and W F (k) respectively denote the consumer surplus and welfare
when ﬁrm N chooses FDI in stage 1. Similarly deﬁne CS F (k) and W F (k) when ﬁrm
N chooses exports. By deﬁnition,
W g (k) = CS g (k) + Z gS (k); g 5 {E, F }.
For a given k, South welfare (W ) is W F (k) if ﬁrm N chooses FDI and W E (k) if ﬁrm
N chooses exports. Since Firm N chooses FDI for k  k(t) we have that(
W F (k) if k  k(t).
W =W E (k) if k > k(t)7Equation (12) ensures that

9c2 (kE kF )(b2c)< 2b .
(9kF 4c2 )(9kE 3c2 )8We are primarily interested in South’s incentive to protect IPR. North always prefers stronger IPR

protection in South because it leads to higher proﬁt for the North ﬁrm (see Proposition 2). Since,in our framework, North welfare consists solely of the North ﬁrm’s proﬁt in South, its welfare is
maximized when IPR protection in South is full, i.e.  = 0.

TRADE, ABSORPTIVE CAPACITY AND IPR

17
2South welfare under FDI, W F , increases as k increases since both CS F  (QF ) /2
and Z FS are increasing in k (Lemma 2). South welfare under exports, W E , increases
with k for analogous reasons. Given the relationship between W E , W F and k, it
immediately follows that the optimal k for South is either 1 or k(t) (which can be 1
for some parameter values). Thus the South government either oers no protection(k = 1) or just enough (k = k(t)) so that the North ﬁrm opts for FDI in South. The
proposition below provides a sharper characterization.
PROPOSITION 5. For a given trade cost t  0, let kW (t) denote the level of IPR
protection that maximizes South welfare. The relationship between t and kW (t) is nonmonotone. More formally, there exists t1 and t2 satisfying 0 < t1  t2 < t̄ < 2b suchthat kW (t) = 1 for t < t1 and t  t̄ while kW (t) = k(t) < 1 for t 5 (t2 , t̄). Furthermore,
kW (t) is strictly increasing in t for all t 5 (t2 , t̄).
Proposition 5 says that if the trade costs are too high or too low, South does not have
any incentive to protect IPR. For a range of intermediate values of trade costs, some
protection of IPR is optimal. Consider ﬁrst t  t̄. From Proposition 4, we know that,for those high values of trade costs, ﬁrm N undertakes FDI irrespective of the strengthof IPR protection. Thus W = W F (k) for all k 5 [0, 1]. As North ﬁrm’s location choice
is not aected by k and W F (k) is increasing in k it immediately follows that kW (.) = 1
for t  t̄.
Now consider the other extreme: t = 0. Proposition 4 says that k(0) = 0 which
implies that ﬁrm N undertakes FDI only if IPR in South is fully protected. Thus
W = W F (k) for k = 0 and W = W E (k) for k 5 (0, 1]. Suppose k = 0, i.e., IPR
is fully protected. Then there is no incentive to invest in absorptive capacity. Sincet = 0 and z E = z F = 0, South welfare under exports and FDI regime are identical;
W E (0) = W F (0). Now for any increase in k from zero, ﬁrm N opts for exports. Since
W E (k) is continuous and strictly increasing in k it follows that welfare is maximized
by setting k = 1. Thus, as in the case of high trade costs, we ﬁnd that no protection
is optimal when t = 0. Standard continuity argument implies that there exists t1 > 0such that no protection of IPR continues to optimal for t < t1 .
For intermediate values of t, i.e. t 5 (t1 , t̄), taking account of location decision byﬁrm N, we get W = W F (k) for k 5 [0, k(t)] and W = W E (k) for k 5 (k(t), 1].
As both W E (k) and W F (k) are increasing in k, the choice of optimal degree of IPR
protection eectively reduces to the comparison between W F (k(t)) and W E (1). In the
Appendix, we show that limt<t̄ [W F (k(t))  W E (1)] > 0. This implies that there exists
a range of trade costs, t 5 (t2 , t̄), such that kW (t) = k(t). For those values of t, theSouth government ﬁnds it optimal to oer some IPR protection, in fact, just enoughto attract FDI. As the trade costs decline, exports become more attractive for ﬁrm N.
Attracting FDI requires more protection of IPR from South which explains the lastpart of Proposition 5: kW (t) is strictly decreasing in t.

18

ARGHYA GHOSH AND JOTA ISHIKAWA

3.6. Discussion. We have made several simplifying assumptions for tractability. Here,
we brieﬂy explore what happens when we relax some of those assumptions.
3.6.1. Enforcement costs. We have assumed that the South government does not incur
any costs for enforcing IPR. Adding enforcement costs to the model does not qualitatively aect our results. Let G(k) denote the cost of enforcing k where G(k) is
continuous and strictly decreasing in k and G(1) = 0. This speciﬁcation captures
the idea that, except for the case of no IPR protection, enforcement is costly andthis cost increases as the degree of IPR protection (to be enforced) increases. Taking
enforcement costs into account we can write South welfare (W ) as(W F (k)  G(k) if k  k(t)W =.
W E (k)  G(k) if k > k(t)Since W g (k) ( g 5 {E, F }) is strictly increasing in k and G(k) is strictly decreasing
in k, it follows that welfare maximizing k continues to be either k(t) or 1. However,the presence of costly enforcement shrinks the range of parameterizations where some
IPR protection occurs in equilibrium.
3.6.2. Taris versus Transportation Costs. Implicitly, we have treated trade costs astransportation costs which involve loss of resources (as in Brander and Krugman, 1981).
Except for subsection 3.5 (where we consider South welfare), the analysis and the results
remain unchanged if we interpret t as tari rather than trade cost. Incorporating tari
revenues in welfare function does not aect the non-monotone relationship between t
and k highlighted in Proposition 5.
When the tari rate is zero or prohibitive, tari revenues do not matter. For boththese cases–which correspond to zero trade costs and prohibitive trade costs in theprevious section–it remains optimal for South to oer no IPR protection at all. Forintermediate values of t, the FDI option becomes less attractive for South. Welfare
under FDI remains same as before, whereas welfare under exports is higher because oftari revenues. Thus the range of values for which optimal kW 5 (0, 1) as well as thevalue of kW will generally be dierent when we treat t as per unit tari instead of tradecost. Nevertheless, the non-monotonicity remains.
3.6.3. Multiple ﬁrms. A natural step is to extend the analysis to incorporate multiple
ﬁrms in both countries - North and South.
Adding more ﬁrms in South is conceptually straightforward. Suppose, as in the mainmodel, there is one North ﬁrm N but two South ﬁrms - ﬁrm S 1 and ﬁrm S 2 with unit
costs c1 and c2 respectively. Firm S l can reduce its unit cost to cl (1  kz l ) wherel = 1, 2 and z l is ﬁrm S l ’s chosen level of absorptive capacity. The algebra is tediousas it involves three ﬁrms with three dierent unit costs but substantive qualitativechanges are unlikely.

TRADE, ABSORPTIVE CAPACITY AND IPR

19Adding more North ﬁrms in the current setup requires some modiﬁcation. Suppose
there is one South, ﬁrm S, with initial unit cost c and two North ﬁrms N 1 and N 2
with zero unit cost. Stage 1 of the model described in 3.1 involves unilateral decision
making by ﬁrm N regarding the choice exports versus FDI. Here, ﬁrms N 1 and N 2 willcompete strategically for the choice between exports and FDI. In particular, whether
ﬁrm N l will choose FDI will depend on whether ﬁrm N h chooses FDI or not (l, h =1, 2, l 6= h). Some modiﬁcation is also needed in modeling South ﬁrm’s investment inabsorptive capacity. Imitation for the South ﬁrm is presumably easier when both ﬁrms
N 1 and N 2 choose FDI as opposed to when only one North ﬁrm chooses FDI. Thus,
in addition to kE and kF , investment cost parameter k will take an additional value
kEF 5 (kF , kE ) which applies when exactly one ﬁrm, N 1 or N 2 , chooses FDI. For arange of parameterizations, there will be two threshold values of k - say, k1 and k2- such that both North ﬁrms choose FDI if k < k1 , exactly one ﬁrm chooses FDI if
k1 < k < k2 and both ﬁrms choose exports if k > k2 . While the analysis will be
involved in this case the spirit of the analysis will be the same as before. The South
government will choose k1 , k2 or 1 as the optimal k depending on whether it wants
both North ﬁrms, one North ﬁrm, or no North ﬁrm to choose FDI.
4. Masking
We have shown that strengthening IPR protection can improve South welfare byaecting the location choice of the North ﬁrm. However, in two extreme but important
cases considered in the trade literature –free trade and prohibitive taris– location
choice is invariant to the IPR policy. Under free trade, FDI does not save any trade
costs because there is no costs to save. The North ﬁrm is better o by opting forexports because imitation is more costly for the South ﬁrm under exports. If taris areprohibitive, clearly, the North ﬁrm always opts for FDI. In those cases, where location
choices are pre-determined by other factors, can some protection of IPR be optimal forSouth? According to our model in the previous section, the answer is no. As we show
below, however, the answer can change once we introduce the possibility of masking.
Whether trade costs are zero or prohibitive, South may have an incentive to protect
IPR.
For the remainder of this section, we consider the case where t = 0 and ﬁrm N always
chooses exports.9 As location choice is unaected by the strength of IPR protection, we
assume away that stage. Suppose prior to ﬁrm S’s investment in absorptive capacity,
ﬁrm N hinders ﬁrm S from imitating technology by undertaking a variety of costly
activities such as creating software programming traps, encrypting important codes, orusing special material to make imitation di!cult. We use masking to denote all suchactivities. Masking raises ﬁrm N’s unit cost from cN = 0 to cN = m. At the same
9The analysis is analogous when t is prohibitive and ﬁrm N chooses FDI.

20

ARGHYA GHOSH AND JOTA ISHIKAWA

time, it increases ﬁrm S’s cost of investment in absorptive capacity. In the absence ofmasking, ﬁrm S’s cost of investment is k while it becomes kM > k under masking.
The timing of the events is as follows:Stage 1 [Masking decision]: Given the degree of IPR protection k, ﬁrm N determines whether or not to engage in masking. Let d denote the binary variable capturing
the masking decision by ﬁrm N:(
1, if ﬁrm N masks its technologyd=0, otherwise
Stage 2 [Investment in absorptive capacity]: Given k and d, ﬁrm S chooses thelevel of absorptive capacity z.
Stage 3 [Cournot competition]: Given k, d, and z, each ﬁrm i chooses qi tomaximize its proﬁts taking rival ﬁrm’s output, qj , as given (i, j 5 {N, S}, i 6= j).
The Cournot equilibrium in stage 3 is now given byb  2dm + c(1  kz)b  2c(1  kz) + dm), q̃S (k, d, z) =,33(b  2dm + c(1  kz))2(b  2c(1  kz) + dm)2
Z̃ N (k, d, z) =, Z̃S (k, d, z) =.
9
9For given k, d, ﬁrm S’s absorptive capacity in stage 2 isq̃N (k, d, z) =z=

2kc(b  2c + dm)
 z(k, d)
9k(d)  4k2 c2

Observe that outputs and proﬁts in stage 2 equilibrium and absorptive capacity instage 3 equilibrium are exactly the same as those obtained in section 3 once we write d =e and m = t. Then, in fact, the game in this section is equivalent to the game describedin section 3. Whether ﬁrm N masks or not in this game is eectively based on the same
calculations that determine whether ﬁrm N exports or not in the game described in
section 3. As we found, contrary to expectation, that equilibrium absorptive capacity
might be higher under exports, here also, we ﬁnd that absorptive capacity might behigher under masking. Masking increases the marginal cost of investment in absorptive
capacity which discourages investment. At the same time, masking increases ﬁrm N’sunit cost by m which raises rival ﬁrm S’s output and encourages ﬁrm S to invest inabsorptive capacity. Thus absorptive capacity might be higher or lower under masking.
This result is similar in spirit to Proposition 2 where we showed that absorptive capacity
might be higher or lower under FDI.
When will ﬁrm N engage in masking in stage 1? If IPR protection is perfect, i.e.,k = 0, ﬁrm S has no incentive to invest in absorptive capacity irrespective of themasking decision. As its technology is fully protected by IPR policy, ﬁrm N does notTRADE, ABSORPTIVE CAPACITY AND IPR

21have any incentive to mask its technology. The following result follows from invoking
standard continuity argument.10
Lemma 3. Firm N does not mask its technology if IPR protection in South is strong
enough. More formally, for all m > 0, there exists k(m) 5 [0, 1] such that ﬁrm N
chooses not to mask in stage 1 if and only if k  k(m).
Now we are ready to examine the IPR policy. For any given choice of ﬁrm N in stage
1 – masking (d = 1) or non-masking (d = 0) – weakening IPR protection reduces
the unit cost of production for ﬁrm S which in turn implies higher consumer surplus aswell as higher proﬁts for ﬁrm S. Thus, IPR protection does not play any role unless it
aects the masking decision. If m is large, ﬁrm N will not mask anyway, while if m issmall, ﬁrm N will always mask. Thus, South’s IPR policy aects the masking decision
only for the intermediate values of m. By inducing ﬁrm N not to mask, the South
government can improve South welfare. The following proposition can be obtained.11
PROPOSITION 6. For a given m  0, let kW (m) denote the level of IPR protectionthat maximizes South welfare. The relationship between m and kW (m) is non-monotone.
There exist m1 , m2 and m3 satisfying 0 < m1  m2 < m3 < 4 such that;A1
if m < m1?
W
k (m) =
k(m) 5 (0, 1) if m 5 [m2 , m3 ] .
A=
1
if m > m3
5. Licensing

In our basic model, FDI is the only mode for ﬁrm N to serve South with prohibitive
trade costs. Then the South government has an incentive to set k = 1 to facilitate
imitation which reduces the production cost of ﬁrm S and increases consumer surplus.
However, anticipating imitation, ﬁrm N might license and transfer its technology to
ﬁrm S. In this section, we introduce licensing into our framework and show thatstrengthening IPR protection may strictly improve South welfare by inducing licensing.
To focus on the comparison between FDI and licensing, we abstract from the optionof exports. This is the case if trade costs are prohibitive. Furthermore, we assume thatin the case of licensing, the eorts to transfer technology are not made by ﬁrm S but
by ﬁrm N. Speciﬁcally, prior to competing in the product market, ﬁrm N, by incurring
a ﬁxed cost L > 0, can license its zero-cost technology to ﬁrm S for an upfront ﬁxed
fee F  0.12 We assume that L < b2 /45 where b is the intercept term in (1). This
10The proof is analogous to that of Proposition 4 once we treat m as t and kE (k F ) as the coe!cientin the cost function, C(z) = kz 2 in case of masking (non-masking).
11The proof as well as the logic underlying Proposition 6 is similar to that corresponding to Proposition

5 and hence is omitted.
12Yang and Maskus (2009) mention “a lump-sum license fee without per-unit royalties captures theempirical reality that a large portion of technology contracts in developing countries have this feature.”

22

ARGHYA GHOSH AND JOTA ISHIKAWA

upper bound on L ensures that licensing occurs for some parameterizations. Firm N
cannot commit not to produce after licensing has taken place. Thus, with or without
licensing, the relevant market structure is duopoly.13 This implies that ﬁrm N builds
a plant in South in both cases. Both ﬁrms N and S enjoy zero unit cost in the case oflicensing. Whereas ﬁrm N’s unit cost is 0, ﬁrm S’s unit cost is c(1  kz) in the caseof FDI. Note that absorptive capacity z 5 [0, 1] matters only in the case of FDI andis exogenously given. This implies that the ﬁrst two stages of the game in section 3.1- location choice and investment in absorptive capacity - are absent. As before, theinverse demand is given by P = b  (qN + qS ).
We have a 2-stage game with licensing decision followed by product market competition. Let u denote the binary variable capturing the licensing decision:(0, if licensing takes placeu=
1, otherwise
Cournot outcomes in stage 2 are given by
b + uc(1  kz)b  2cu(1  kz), q̃S (k, u) =,3
3
(b + cu(1  kz))2(b  2cu(1  kz))2Z̃ N (k, u) =, Z̃ S (k, u) =.
9
9
In Stage 1, i.e., the licensing stage, we assume that ﬁrm N makes a take-it-or-leave-itoer to ﬁrm S. Firm N incurs L with licensing:q̃N (k, u) =b2b2
 L + F, ZS (k, 0) =  F,
99(b + c(1  kz))2(b  2c(1  kz))2
Z N (k, 1) =, Z S (k, 1) =.
9
9The upfront ﬁxed licensing fee is given by
Z N (k, 0) =4c(1  kz)(b  c(1  kz)),
9whenever licensing occurs in equilibrium, i.e., whenever the joint proﬁts are higher
under licensing:
F = Z̃S (k, 0)  Z̃S (k, 1) =Z N (k, 0) + Z S (k, 0)  Z N (k, 1) + Z S (k, 1)/ c(1  kz)(2b  5c(1  kz))  9L  0/ c(1  kz) 5 [c1 , c2 ],II22
where c1  b3 b5345L and c2  b+ b5345L .
(13)

Decomposing (13) further provides a more comprehensive picture of licensing whichis articulated in the following Lemma.

13For example, Kabiraj and Marjit (2003) and Mukherjee and Pennings (2006) impose a similarassumption.

TRADE, ABSORPTIVE CAPACITY AND IPR

23c2
Lemma 4. (i) If c < c1 or c > 13z
licensing does not occur in equilibrium irrespectiveof k.
c1(ii) If c 5 [c1 , 13z] licensing occurs if and only if k  k̃1 (c)  z1 (1  cc1 ).
c1(iii) If c 5 [ 13z, c2 ] licensing occurs for all k.
c2(iv) If c 5 [c2 , 13z] licensing occurs if and only if k  k̃2 (c)  z1 (1  cc2 ).

Lemma 4(i) says that licensing occurs when ﬁrm S’s initial unit cost c is not toohigh or not too low. If c is too high then ﬁrm N does not want to relinquish its almostmonopoly position by licensing its zero-cost technology to ﬁrm S. If c is too low thenincurring L is not worthwhile for ﬁrm N. For intermediate values of c licensing takes
place.
c1
Consider parameterizations in Lemma 4 (ii): c1 < c < 13z. If there is no IPR
protection (i.e., k = 1), then we have c(1  kz) = c(1  z) < c1 , where the inequalityc1
follows from c1 < c < 13z. In view of (13), therefore, licensing does not occur. However,
if IPR protection is perfect (i.e., k = 0), then c(1  kz) = c > c1 holds and hence
licensing takes place. This suggests that, for parameterizations considered in Lemma
4 (ii) licensing occurs in equilibrium if IPR protection is strong enough. Exactly thec2
opposite holds for c2 < c < 13z. If IPR protection is perfect, then we have c(1  kz) =c2
c > c2 with c2 < c < 13z and it follows from (13) that licensing does not occur.
However, in absence of any IPR protection c(1  kz) = c(1  z) < c2 and licensing
occurs. Thus, here licensing occurs if IPR is weak enough. In the intermediate range
c1
c 5 [ 13z
, c2 ], it is easy to show that no matter what k is licensing takes place.
Let us now turn to welfare. South welfare under licensing and no-licensing respectively are
2b2 (b  2c(1  kz))2+,99(2b  c(1  kz))2 (b  2c(1  kz))2
W F (k) =+,18
9where the ﬁrst term in the welfare expression is consumer surplus and the second termis product market proﬁts less ﬁxed fee F (if any). The second term in the two welfare
expressions are the same since ﬁrm N makes a take-it-or-leave-it oer to ﬁrm S. Thatis, ﬁrm N oers ﬁrm S just enough so that ﬁrm S is indierent between licensing andno-licensing. Consumer surplus is larger with licensing than with FDI. This is because,in the case of licensing, both ﬁrms N and S enjoy zero unit cost and hence the goods
price is lower. Thus, W L (k) > W F (k) holds.
Let kW denote the value of k that maximizes South welfare. Consider ﬁrst c < c1 or
c2
c > 13z. For such parameter values licensing does not occur for any k. Thus, welfare
is given by W F (k) which is maximized at k = 1 because it is increasing in k. Now
c1
consider c 5 [ 13z, c2 ] for which licensing occurs irrespective of k. Here, welfare is given
L
by W (k) which is strictly increasing in k and hence maximized at k = 1. Thus,
W L (k) =24

ARGHYA GHOSH AND JOTA ISHIKAWA

c2
c1
c2
kW = 1 whenever c < c1 , or c > 13z
or c 5 ( 13z, c2 ). Indeed, for c 5 (c2 , 13z), kW = 1 as
well. To see why, note that licensing occurs k  k̃2 (c)  1z (1  cc2 ) [see Lemma 4(iv)].
Thus, licensing occurs when k = 1. Then the claim kW = 1 follows from noting that
W L (1) > W F (1) and both W L (k) and W F (k) are increasing in k.
c1
The discussion above suggests that kW < 1 can hold only if c 5 (c1 , 13z). For suchc1
1
parameterizations licensing occurs if and only if k  k̃1 (c)  z (1  c ). The South
government could choose k = k̃1 (c) and ensure licensing or it could choose k = 1
in which case licensing does not take place. Our last proposition conﬁrms indeed
the welfare maximizing South government would choose k = k̃1 (c) for a subset oc1c 5 (c1 , 13z) and ensure that licensing takes place.14

PROPOSITION 7. Let kW (c) denote the level of IPR protection that maximizes
South’s welfare. The relationship between c and kW (c) is non-monotone. There exc1
ist c3 satisfying c1  c3 < 13z
such that;A1
if c < c3?
Wc1
k (c) =k̃1 (c) 5 (0, 1) if c 5 [c3 , 13z
] .
A
=
c1
1
if c > 13z
The following should be noted. In our basic model, ﬁrm N will serve South throughexports under free trade. Then the South government has an incentive to set k = 1 tofacilitate imitation. If licensing becomes an option for ﬁrm N to serve South in thissituation, we can make a similar comparison between exports and licensing. We caneasily verify that the results are qualitatively the same. That is, strengthening IPR
protection may strictly enhance South welfare by inducing licensing.
6. Concluding Remarks
We examined South’s incentives to protect IPR in an environment where the strengthof IPR protection in South has no bearing on North ﬁrm’s incentives to innovate. In thepresence of (i) endogenous absorptive capacity and (ii) North ﬁrm’s location choice–both endogenously determined in our framework–, we found that South can beneﬁt
from having strict IPR protection depending on the level of trade costs. We also foundthat the relationship between the optimal strength of IPR protection in South andtrade costs is non-monotone. If the trade costs are too high or too low, there is no
incentive to protect IPR in South. For moderate values of trade costs, however, it is
optimal for South to protect IPR to some extent. In this range of values for trade
costs, the IPR protection becomes stronger as the trade costs decline.
We speciﬁcally extended our basic model into two directions. We introduced the possibility of North’s masking technology in one extension and the possibility of North’s
licensing in the other. We showed that in the presence of masking or licensing, some
14The proof is similar to that of Proposition 5 and hence is omitted.

TRADE, ABSORPTIVE CAPACITY AND IPR

25

protection of IPR might be optimal for South even if the trade costs are zero or prohibitive.
Our analysis also oers an explanation for the ambiguous relationship between FDI
and spillovers which is often observed in the data. Key to our explanation is the roleof absorptive capacity. Under FDI, absorption is less costly but the South ﬁrm faces
stronger competition since the North ﬁrm saves trade costs when it opts for FDI. As aconsequence, we found that absorptive capacity/spillovers can be higher or lower under
FDI.
Note that a common theme across all three stories referred to in this paper –FDI,
masking, and licensing– is that IPR protection improves South welfare by inducing aswitch of regimes: from exports to FDI in section 3, from masking to non-masking insection 4, and from no licensing to licensing in section 5. To highlight these channels
clearly, we have focused on the case of an international duopoly (i.e., a single ﬁrm ineach country). This setup or an extension of this setup with a few oligopolistic ﬁrms
captures important part of reality but it also results in lots of discontinuities which
complicates the analysis. An alternative is to consider monopolistic competition withﬁxed number of ﬁrms.
Furthermore, throughout the paper, we have focused on a 2-country model wherea North ﬁrm locates in South to serve South consumers. Motta and Norman (1996),
Ekholm, Forslid and Markusen (2007) and most recently Tintelnot (2017) have pointed
out that North ﬁrms locate in South not necessarily to serve South consumers but
to serve consumers in other export markets, i.e., use South as an export platform.
Trade liberalization in such environments can have nuanced eect on IPR policies. If
North faces lower taris from South, exports might become more attractive. On theother hand, if South faces lower taris from other export markets, FDI becomes more
attractive. Extent of tari reductions as well as dierences in market size will play animportant role in determining the eect of trade liberalization on IPR protection. Bothissues: monopolistic competition and export-platform FDI are left for future research.

26

ARGHYA GHOSH AND JOTA ISHIKAWA

Appendix
Proof of Lemma 2: (i) Using (5) and (7) we get(b + c(1  kz(k, 0)))2.
9
By Proposition 1(i), z(k, 0) is increasing in k. This implies that cS = c(1  kz(k, 0))is decreasing in k which in turn implies that Z FN decreases as k increases. The proof is
analogous for Z EN.
(ii) See the paragraph after Lemma 2 in the text.
(iii) Using (4) and (7) we get QF = 2b3c(13kz(k,0))
and QE = 2b3t3c(13kz(k,1)). Then,3
3
applying the argument presented in the proof of (i) gives the results.
¤
ZFN = Z̃ N (k, 0, z(k, 0)) =Proof of Proposition 2: The ﬁrst part of the proof essentially restates (10). Thatt̃(k) is increasing in follows directly from observing the expression of t̃(k) in ﬁrst partof the Proposition.
¤
Proof of Proposition 3: (i) Dierentiating z(k, e) with respect to c, we get:2k[4k2 bc2 + (8k2 et  36k(e))c + 9k(e)(b + et)]dz(k, e)=.
dc
(9k(e)  4k2 c2 )2dz(k,0)2kb= 9k=
Consider z F = z(k, 0). For all k > 0, limc<0 dz(k,0)
F > 0 while limc< b
dc
dc
2
2kb
2 2
 9kF 3k2 b2 < 0. These limit values together with the fact that 4k bc 36k(e)c +9k(e)bT
is quadratic in c imply that there exists a unique cF (k) 5 (0, 2b ) such that dz(k,0)
dc

0 / c S cF (k). Now consider z E = z(k, 1). We have that limc<0 dz(k,1)= 2k(b+t)
>0
dc
9kE
E

2 2

E

2 2

+k b )
3k b )=  2k(9k[t  b(9k] which is strictly negative if and only
and limc< b dz(k,0)
dc(9kE 3k2 b2 )2
9kE +k2 b2
2

E

2 2

3k b ) b
if t < min{ b(9k, 2 }. The claim then follows from applying argument similar to
9kE +k2 b2
the ones used for the FDI case.
¤F(ii) Consider the following set of parameterizations: b = 4, k = 1,and k = 1. For969952
c1 = 45 and c2 = 11
, we ﬁnd that z 1 = 161, z 2 = 104, c1S = c1 (1  kz 1 ) = 161
and
10
11
2
2
2
1
2
1
2
cS = c (1  kz ) = 208 . Observe that c < c and yet cS > cS .
¤F
E
Proof of Proposition 4: Noting (11), we obtain Z N  Z N  0 / (k, t)  0 where(k, t)  2k2 c2 [9(kE  kF )(b  2c)  t(9kF  4k2 c2 )]  2t(9kF  4k2 c2 )(9kE  4k2 c2 ).
We have
9c2 (kE 3kF )(b32c)(a) (0, t) = 162kE k F < 0, and (1, t) > 0 for all t < (9kF 34c2 )(9kE 33c2 )  t̄,
2 2
F
2 2
F
2 2
E
(b) t (k, t) = [2k c (9k  4k c )  2(9k  4k c )(9k  4k2 c2 )] < 0,(c) k (k, t) = 4kc2 [9(kE  kF )(b  2c) + 4t(9kE  4k2 c2 ) + 2t(9kF  4k2 c2 ) + 4k2 c2 ] > 0.
It follows form (a) and (c) that there exists k(t) 5 (0, 1] such that k  k(t) ,t (k,t)0
Z FN  Z E
N  0 for t < t̄. Also, for all t < t̄, k (t) =  k (k,t) > 0 which implies k(t) isstrictly increasing in t. For t > t̄, k(t) = 1 and consequently k0 (t) = 0.
¤TRADE, ABSORPTIVE CAPACITY AND IPR

27

Proof of Proposition 5: In the main text, we showed that kW (t) = 1 for t  t̄. We
also proved that there exists t1 > 0 such that kW (t) = 1 for t  t1 . Here, ﬁrst we provethat there exists t2 < t̄ such that kW (t) = k(t) < 1 for all t 5 (t2 , t̄). Suppose t1 < t < t̄
and let t $ t̄. From Proposition 4 we already know that for all such t ﬁrm N chooses
FDI if k  k(t) and k(t) < 1. It su!ces to show that limt<t̄ [W F (k(t))  W E (1)] > 0.
Denote z F and z E in equations (8) and (9) as z F (k) and z E (k) respectively. For any
given k 5 [0, 1],[2b  c(1  kz F (k))]2 [b  2c(1  kz F (k))]2+
 kF (z F (k))2 ,18
9[2b  c(1  kz E (k))  t]2 [b  2c(1  kz E (k)) + t]2+
 kE (z E (k))2 .
W E (k) =18
9Continuity of k(t) in t implies that limt<t̄ k(t) = k(t̄) = 1. This ﬁnding, together with
continuity of W (k) in k, implies that
W F (k) =lim W F (k(t))  W E (1) = [W F (1)  W E (1)]t<t̄ .
t<t̄

It follows from (11) that kc(z F  z E )  2t = 0 if ﬁrm N is indierent between exports
and FDI. Using this, we obtain[W F (1)W E (1)]t<t̄ =t̄[24b  30c + 15cz F (1) + 15cz E (1) + 3t̄](kF (z F (1))2 kE (z E (1))2 ).
18

qg
Equating marginal cost with the marginal beneﬁt of investment in z gives kg z g = 2kc
3 S(g 5 {E, F }) Using this, we have the following with k = 1:2c F[(q  qSE )z F (1) + qSE (z F (1)  z E (1))]
3 St̄[12cz F (1) + 8b  16c + 16cz E (1) + 8t̄].
=18

k F (z F (1))2  kE (z E (1))2 =The last equality follows from qSF  qSE = t̄ where the equality holds because c(z F z E )  2t = 0 with k = 1. Then we obtaint̄[16b  14c + 2cz E (1) + t̄]>0
18
That kW0 (t) > 0 for all t 5 (t2 , t̄) follows from noting that (a) kW0 (t) = k0 (t) for thesevalues of t and (b) k0 (t) > 0 (by Proposition 4).
¤[W F (1)  W E (1)]t<t̄ =28

ARGHYA GHOSH AND JOTA ISHIKAWA

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