Intellectual Property Rights, Internalization 

and Technology Transfer*

Michael W Nicholson**

Federal Trade Commission 

Abstract 

Intellectual property protection affects the manner in which multinational enterprises 

facilitate technology transfer from the innovating North to the developing South. Firms with 

products that are complex or technologically sophisticated will tend to internalize production 

through foreign direct investment. Firms that face a lower risk of imitation, or are less 

technically advanced, will tend to license production to non-affiliated Southern firms. Changes 

in intellectual property protection affect the level and the composition of technology transfer, 

depending on the value of the firm’s proprietary asset. 

General field: International Trade, Industrial Organization 

JEL Classification No.: F23, L24, O34 

Key Words: multinational enterprise, licensing, intellectual property rights, technology transfer, 

foreign direct investment

 

*

The views expressed in this paper are those of the author and do not necessarily represent the views of the Federal 

Trade Commission or any individual Commissioner. Christopher Adams, Yongmin Chen, Judy Dean, Jason Green, 

Russell Hillberry, James Markusen, Keith Maskus, Christine McDaniel, Jason Moule, and an anonymous referee 

provided helpful comments. I have also benefited from seminar participants at the U.S. International Trade 

Commission, American University, the World Bank Group, and the Mid-west International Economics Meeting 

held at the University of Wisconsin (Spring 2001). 

**Bureau of Economics, Federal Trade Commission, 600 Pennsylvania Ave NW, Washington, DC 20580, U.S.A., 

phone: 1-202-326-3233, fax: 1-202-326-3443, e-mail: mnicholson@ftc.gov. 
1

1 Introduction 

This paper analyzes the manner in which multinational firms facilitate technology 

transfer from industrialized countries (North) to countries just removed from the world’s 

technology frontier (South), and the role played by Southern policies regarding intellectual 

property protection. Recognizing the empirical regularity that industries respond to intellectual 

property rights (IPRs) differently, the model clearly distinguishes firms based on inherent 

characteristics directly related to intellectual property and its protection, which explain various 

responses to policy on IPRs. The impact of IPRs on different firms’ entry decisions alters both 

the level and composition of technology transfer to the South. The results suggest that stronger 

IPRs lead to an overall increase in technology transfer, but may change its composition from 

foreign direct investment (FDI) to arms-length licensing. 

 Intellectual property protection plays an important role in technological development and 

dissemination, supporting incentives for innovation and helping to determine conditions under 

which technology will be transferred. Technological innovations, which are generally 

characterized as intellectual property, are costly to develop but can be relatively cheap to imitate 

in many industries. Stronger IPRs in developing countries may encourage market-based 

transactions of technology, but hinder access to the technological frontier by domestic firms by 

extending the protected property of foreign innovators.1

 The activity under analysis is prior to the actual impact of the technology transfer on host 

countries, especially through non-market spillovers. A substantive economic literature on the 

impact of foreign direct investment on the host countries provides weak evidence that FDI 

 

1

 See Maskus (2000) for a detailed discussion of this point. 
2

generates positive spillovers.2 In the present analysis, however, the technology transfer occurs 

by intentional decision of the firm3, and the actual impact of the transfer is outside the scope of 

this paper. It remains an open question, especially when noting that, to my knowledge, no study 

investigates the impact on host countries of technological spillovers related to cross-border 

licensing. 

In the model, each firm has a monopoly on the latest quality innovation for its particular 

good and decides among three ways to service the Southern market—exporting, licensing, or 

FDI. The influence of IPRs on this decision involves the market imperfections surrounding the 

new innovation. The firm’s knowledge of this technical innovation is the proprietary asset that 

gives it an ownership advantage. This knowledge is non-rival, and others can use it in direct 

competition if the firm cannot preserve the monopoly. Monopolistic power of the proprietary 

asset can only exist as long as the good is excludable, which relates directly to the strength of 

IPRs. 

 Economic theory suggests that IPRs encourage market-based cross-border technology 

transfers, although, as Smith (2001) points out, the theoretical impact of IPRs on the marginal 

substitution between FDI and licensing is ambiguous. Dunning (1981) outlines the motivation 

 

2

 In particular, Haddad and Harrison (1993) find weak plant-level productivity growth negatively correlated with 

foreign presence in Morocco, and Aitken, Hanson and Harrison (1999) find similar results for Venezuela. Kokko 

(1994) finds that spillovers are less likely in “enclave” sectors with large technology gaps and high foreign shares. 

A review by Hanson (2001) suggests that domestic plants in industries with a large multinational presence actually 

realize lower rates of productivity growth. 

3

 To help clarify the difference, Grossman and Helpman (1991) define technological spillovers occurring when 

firms acquire information created by others without paying for it in a market transaction, and the creators (or current 

owners) have no effective recourse under prevailing laws (such as those protecting IPRs) to prevent other firms 

from utilizing information so acquired. This quality highlights the partial excludability of knowledge goods, and 

serves as a primary theoretical benefit of FDI (Wang and Blomstrom 1992). Unintentional spillovers, or “leakages”, 

can occur in a variety of ways across national borders. Reverse engineering, similar to imitation, describes the 

process of developing a competing product using the original. This method is generally employed in fields in which 

innovative qualities can be easily mimicked, such as certain chemicals. Leakages also occur through defection, 

when a former employee begins working for a competitor, through the emigration of high-skilled workers, or when 

a firm breaks a licensing contract to produce its own good absent of royalties. 
3

for firms to service a foreign country with products based on proprietary technology. Firms may 

choose to shift production overseas in place of exports if sufficient location advantages are 

present. Once firms have decided to service a foreign country with proprietary technology, they 

will do so by foreign direct investment if the returns to internalization exceed those of licensing. 

Although there are many general determinants of FDI—including market size, 

transportation costs, and tax incentives—the fear of losing control of the proprietary asset is the 

major theoretical consideration on the margin between FDI and licensing (Horstmann and 

Markusen 1987). IPRs affect the risk of losing control by making imitation more costly 

(possibly by expanding the distance in product space required for the introduction of a 

competitive product) or by strengthening contract rights, thereby increasing bargaining power 

and royalty rates for licensors (Gallini and Wright 1990, Helpman 1993, Glass 1997, Smith 

2001, Markusen 2001). 

Imperfect protection of intellectual property allows for knowledge to leak to competing 

firms, a dissipation of the proprietary asset commonly referred to as imitation. This non-market 

method of technology transfer provides no return to innovating firm. Imitation could be the 

direct copying of an existing good, or the development of a “knock-off” product. A wider scope 

of IPRs prevents imitation so that an imitating firm must establish a larger distance from the 

original good in technology space. Weaker patent laws allow for closer substitutes to compete 

against the original commodity. 

If the Southern wage is low enough relative to the North to provide a location advantage 

for a firm, it will shift production to an overseas affiliate. The multinational firm then seeks a 

patent to protect the new technology from Southern firms. The level of IPRs in the South affects 

the probability that this imitation will successfully infringe on the multinational firm’s ownership 
4

advantage. Firms internalize production, rather than license or export, if FDI offers a better 

return. Internalization advantages usually arise in the presence of information asymmetries. The 

Northern firm must signal the quality of its innovation to any potential licensees without 

revealing sufficient knowledge to a potential Southern licensee that may defect and sell a 

competing product (Markusen 1995). 

Many authors model these information asymmetries as a signaling game about the quality 

of the innovation.4 I model the contract as a self-enforcing mechanism. Due to the threat of 

defection, any licensing contract signed will be self-enforcing, wherein terms of the contract are 

such that the licensee will be better off not defecting. If a self-enforcing contract cannot be 

found, firms will not license.5

 The level of IPRs directly influences the conditions on which 

these contracts can arise. 

No existing theoretical model differentiates industry characteristics that affect a firm’s 

response to IPRs, however, despite the established notion that industries respond to IPRs 

differently.6

 Mansfield’s (1994) survey results show that the importance of IPRs in a firm’s 

technology transfer decision is highly correlated by industry. In particular, firms in the chemical 

and electrical equipment industries consistently reported that IPRs were too weak to permit 

licensing of their latest technology, but metals firms were relatively unaffected by IPRs. 

Mansfield finds that firms in the chemicals, pharmaceuticals, electrical equipment, and 

 

4

 Horstmann and Markusen (1987), Gallini and Wright (1990), and Vishwasrao (1994) are all examples of models 

that use signaling. 

5

 Ethier and Markusen (1996), Markusen (2001), and Yang and Maskus (2001) are models that use this selfenforcing contract mechanism. 

6

 Markusen (2001) includes an extension with firms that have large fixed costs, so that the optimal level of IPRs 

may be set to induce the entry of the second firm, and Glass and Saggi (1998) model FDI in two states of nature, 

where the South may be one or two levels away from the technology frontier. Neither of these, however, captures 

the differences in the nature of the product produced that affect a firm’s response to IPRs. 
5

machinery industries place a larger emphasis on IPRs regardless of country.7 He suggests that 

the industries unaffected by IPRs may require expensive or complex inputs protecting them from 

imitation, but that the industries greatly affected (in particular, chemicals) may be influenced by 

the coverage of particular laws protecting intellectual property. 

This evidence supports survey results from Levin et al (1987) which demonstrate that 

different industries may carry dramatically different responses to the incentives offered by 

patents. According to the Levin survey, the dominant methods for the appropriation of new 

innovations in most industries include proprietary secrets and lead time. In chemicals, however, 

patents (i.e., IPRs) served as the primary method of appropriation. Overall, the sectors that gave 

the highest ratings to patents were: petroleum refining, drugs, plastics, inorganic chemicals, and 

organic chemicals. 

 Cohen et al (2000), in an update of the Levin survey, discuss the characteristics of R&D 

in the chemical industry that may explain this ambiguous dependence on patents. They stress a 

distinction between “discrete” product industries such as drugs, chemicals, and biotechnology, as 

opposed to “complex” industries such as electronics and scientific instruments, a classification 

introduced by Merges and Nelson (1990). The key difference involves the number of separately 

elements in an innovation subject to patenting. In the complex industries, patents are generally 

devices used to block a rival’s innovation with complementary technologies. In discrete 

industries, every new innovation enjoys a unique patent, and thus patents are the dominant 

method of appropriation.8

 

7

 Smarzynska (2000) demonstrates that these four industries will tend to build wholly-owned subsidiaries in the 

presence of weaker protection. 

8

 Anand and Khanna (2000) investigate the structure of licensing contracts within the Chemicals, Computers, and 

Electronics industries. They find that the high incidence of licensing contracts in these “high-tech” industries 

reflects the volume of technology available, but licensing is a less likely outcome for weakly patented technologies. 

They show that licensing increases with IPRs and propose that cross-industry variation may be a valuable 
6

The present paper captures these cross-sectoral differences by distinguishing 

multinational firms by the type of industry they represent. I suggest industries may realize 

different impacts between dependence on intellectual property and intellectual property rights. 

Firms dependent on intellectual property are vulnerable to imitation because their profit stream 

would be at risk should they lose control over their proprietary asset. Firms dependent on IPRs 

may not necessarily have substantial intellectual property at the core of their business, but will 

be vulnerable because their proprietary asset can be easily replication. The model provides 

similar motivation across industries for shifting production to overseas affiliates due to identical 

rents achieved through patent-induced monopolistic control of innovations. The relative role for 

technology transfer varies by industry. Thus, industry characteristics of multinational firms 

affect the relevance of Southern policy on IPRs. 

2 The benchmark model 

2.1 Basics 

There are two regions in the model: the North, which houses all innovating firms; and 

the South, which houses all imitating firms. Goods are indexed j along a continuum from (0,1), 

which means a fixed variety of goods exists, each of which can be improved in quality. For 

every good, there is a corresponding firm in the North can produce only that good. Each 

Northern firm realizes an exogenous innovation on the quality of the good it produces at the 

beginning of every time period t,. This quality improves the utility gleaned from the good by the 

multiplicative value q (where q>1). That is, starting at quality level 1, the next improvement 

yields a quality q, the next improvement a quality level q2

, and so on. For every innovation, 

 

explanation for this empirical regularity. 
7

consumers are willing to pay q times the price of the most recent level of quality. 

Firms have a monopoly on the innovation, but with the innovation the knowledge of all 

previous quality levels is dissipated and that good is produced competitively. Thus, at the 

beginning of every time period, firms own the rights to the latest quality level for their particular 

good, but every other firm in the world can produce and sell the q-1 quality level of the good 

innovated in the previous time period t-1. As shown below, the innovating firms set prices to 

capture the entire market for each type of good. 

2.2 Shifting production

In order to service the Southern market with the latest innovation, Northern firms 

produce the good domestically and then export it, or they can choose to shift production to the 

South and take advantage of lower factor costs.9 Labor is the only input in the model, and for 

simplicity I assume no transportation costs. Appendix A.1 works through the fundamental 

equations of the model with a parameter for trade costs, which adds complexity to the basic 

model without additional theoretical insights. Transportation costs can be understood simply as 

part of the wedge between relative wages. 

If the relative wage is attractive enough for firms to shift production, they can choose 

between licensing the new technology to a Southern firm, or by internalizing production within 

their own subsidiary. I call any firm that shifts production a multinational enterprise. When they 

internalize production within an affiliated subsidiary, I call the activity FDI. Firms choose 

between licensing and FDI depending on characteristics of the Southern market and their own 

industry. If FDI is chosen, the firm must pay a fixed cost F to cover the establishment of a new 

plant and faces the probability μ that imitation will lead to dissipation of the firm‘s proprietary 

 

9

 In contrast to Hortsmann and Markusen (1987), who use a “licensee cost advantage” for both licensing and FDI to 
8

asset.10 

I assume there can be no imitation of exported goods, which focuses the model on the 

relationship between FDI and licensing. 11 The imitation risk in the model for the multinational 

is defection, an assumption that finds support in anecdotal examples. Smarzynska (2000) refers 

to case studies of multinationals in Eastern Europe and China that fear the future presence of 

competing goods produced by virtue of defection. Markusen (2001) cites evidence from Hobday 

(1995) that many managers of local companies in Latin America and East Asia are former 

employees of multinational firms. 

These costs and risks of licensing are covered by the firm offering a self-enforcing 

contract to the licensee, in which remaining under contract is more attractive to the producing 

firm than defecting and starting a rival plant. A contract is self-enforcing if the returns to 

defection are lower than the returns to remaining under contract. Suppose that a defecting firm 

successfully produces a competing product at rate λ dependent on the level of IPRs. In order to 

prevent this defection, a licensor simply offers a rent-sharing contract worth at least λ. With 

stronger IPRs, the rate of successful imitation goes down, so an innovator can write a contract 

that preserves its rents. Thus, the incentive for licensing increases with IPRs. 

The benefits and costs for the three modes of entry are outlined in Table 1. Exporting 

firms produce in their domestic plant, so they pay no fixed costs for production. With no reverse 

engineering, they also maintain secrecy of their technology and thus do not face any risk of 

dissipation of their proprietary asset. In addition, they earn the full rents from the sales of the 

 

occur in equilibrium, I assume symmetry of marginal cost for all Southern production. 

10 Vishwasrao (1994) assumes firms that internalize cannot be imitated, while those that license face the possibility 

of imitation. I allow for the defection of a licensee, but such that it will not occur in the presence of a self-enforcing 

contract. Imitation of FDI allows the model to capture the influence of IPRs on the exporting-versus-FDI decision. 

11 I show in Appendix A.2 the changes in the model if reverse engineering is possible. The fundamental trade-offs 

remain unaltered, but the parameter space conducive to exporting shrinks. 
9

good. These rents, however, are lower than if production were shifted, due to the higher 

marginal cost of production in the North. 

Licensing firms benefit from the lower Southern wages, and thus earn higher rents. They 

only earn the royalty rate (1-λ) from the sales of their goods, which captures the risk of 

defection.12 Firms that engage in FDI earn the full rents from Southern production. The 

disincentives for FDI include the fixed cost F of establishing the overseas subsidiary and the risk 

of imitation by a Southern firm. 

Table 1: The three modes of entry 

Mode of Entry Benefits Costs 

Exporting • Pay no fixed costs 

• Face no risk of 

dissipation 

• Earn full rents 

• Pay higher marginal cost w>1 

• (no transportation costs) 

Licensing • Pay lower marginal cost 

• No fixed costs 

• No explicit risk of 

dissipation 

• Earn (1-λ) of rents, which 

implicitly covers the risk of 

defection 

FDI • Pay lower marginal cost 

• Earn full rents 

• Pay fixed cost F 

• Face risk of dissipation μ

The decision between licensing and FDI is independent of the relative wage since both 

use the same costs of production. The incentives for internalization (i.e., FDI) increase as λ

increases or as F or μ decrease. As shown below, the incentive for FDI relative to licensing also 

increases with the rents from overseas production. 

Exporting yields rents E. Overseas production as a monopoly earns rents R, but after 

dissipation earns duopoly rents D. Licensing firms receive (1-λ)R. multinational firms earn R 

 

12 Markusen (2001) and McDaniel (2000) both assume fixed costs for both FDI and licensing, where the fixed cost 
10

with probability (1-μ) and D with probability μ, and pay the fixed cost F. A firm will choose to 

shift production if the returns to exporting are lower than either the returns to licensing or FDI. 

With risk neutrality, the firm will choose to shift production if the following two conditions hold: 

(1-μ)R + μD – F > E (1) 

and 

(1-λ)R > E. (2) 

If both inequalities for (1) and (2) hold, the firm will choose between licensing and FDI based on 

the expected returns from both. The firm will choose to engage in FDI if: 

(1-μ)R + μD – F > (1-λ)R. (3) 

2.3 Profit Equations 

Following Grossman and Helpman’s (1991) quality-ladders model, both the quantity and 

the quality of each good consumed provides utility for the time period t. Consider, across all 

goods, the instantaneous logarithmic utility function and budget constraint, 

= ∫ ∑ 1

0 log ( ) log[ ( ) ( )] k k kt u t q j x j dj ∫ = 10 . . j j wsLs st p x dj , (4) 

where qk(j) is the quality level k of good j consumed, and xkt(j) is the amount of quality level k of 

good j consumed at time t. The innovations improve a good relative to itself, so without loss of 

generality the naught quality level can be normalized q0(j)=1 leaving qk(j)=qk

, where k is not a 

superscript but an exponent. 

 The elasticity of substitution is constant among types of goods. Consumers thus spend a 

constant proportion of their income across the product line, purchasing only the quality level 

sold for the lowest price, per unit of quality, for each type of good j. Firms compete in price to 

signal the quality of their good. The goods at technology levels q-1 and below are produced and 

 

of licensing is lower. I assume costless licensing. 
11

sold competitively throughout the world, and since the lowest marginal cost is the Southern 

wage, these goods are priced ws. For simplicity, normalize everything to this wage, so that ws = 

1. Profit-maximizing firms with proprietary control of an innovation thus charge (q-ε)ws, 

capturing the entire market. As ε→0, this limit price is qws = q. 

With symmetrical demand for all varieties of goods j, consumers split their income 

evenly along the continuum. Thus, the quantity sold depends only on the size of the Southern 

market Ls, 

xj=Ls/pj , (5) 

which is the same for all xj, since the price of the latest generation of goods are all q. Profits are 

given by the difference between price and cost times quantity, 

j

s

j j p

L

π = ( p − w ) . (6) 

The only difference between exporting profits and multinational firm profits is the marginal cost, 

or wage, since the price does not change. Define the relative wage w ≡ wn/ws = wn so that 

s

s

s

s n L

q

w

q w

L E q w w (1 ) * = ( * − ) = −

 (7) 

s

s

s

s s L

q w q

L

R q w w )

1 (1

* = ( * − ) = −

. (8) 

With this price competition, a second competitor bids the price down to cost, and duopoly profits 

following imitation are, then, zero. Therefore, 

D = 0 (9) 

and 

q

L R E w s − = ( −1) . (10) 
12

 From (1), firms choose FDI over exporting if (1-μ)R - F > E. Plugging in for R and E 

and solving for the relative wage yields 

R

F

q q

w

+ + − > − μ 1

1

1 . (11) 

 A firm will prefer FDI to exporting if the relative wage is high with respect to the righthand side of (11).13 The value of the wage that determines this decision increases as F or μ

increase. When the disincentives for FDI are higher, a larger wedge between Northern and 

Southern wages is necessary to induce overseas production. 

 From (2), firms choose licensing over exporting if (1-λ)R > E. Plugging in for R and E 

yields 

+ λ − > − 1

1

q 1 q

w . (12) 

Similarly, a firm prefers FDI to licensing if (1-μ)R – F > (1-λ)R, which simplifies to 

R

F λ > μ + . (13) 

This is a key relationship in the model. If the disadvantage of licensing – the lost royalties – is 

greater than the disadvantages of FDI – the risk of imitation and the fixed cost – then firms 

prefer to internalize production. The effect of the fixed cost diminishes with the monopoly rents, 

since the actual capital loss diminishes with the size of the market (see McDaniel 2000). 

 Notice that if (11) holds and (12) does not, then (13) must hold. That is, if a firm prefers 

FDI to exporting, and exporting to licensing, then it prefers FDI to licensing. This transitivity 

feature holds for each relationship. 

 

13 I divide by (q-1) to simplify the expression. Since there is no loss of generality, I continue to refer to w/(q-1) as 
13

3 Intellectual property and the mode of entry 

3.1 The relative wage and IPRs 

 The relationships between the relative wage and various parameters of the model 

determine the firm’s mode of entry. The rate of imitation decreases with stronger intellectual 

property protection, which captures the effects of IPRs with respect to the dissipation of the 

proprietary asset. With stronger protection, potential imitators must invest more resources to 

circumvent existing laws, to establish “knock-off” products farther from the original in 

technology space, or to account for other effects of IPRs. With stronger IPRs, the right-hand 

side of (11) drops, and firms require a lower wedge in marginal cost to prefer FDI to exporting. 

Stronger IPRs also lowers the licensor’s royalty receipts, as described in Section 2.2. With 

stronger protection, a firm can lower its rent-sharing fee λ. The right-hand side of (12) drops, 

and firms are more likely to prefer licensing to exporting. 

3.2 Graphical analysis 

The relationship between the relative wage and IPRs derived in (11) – (13) can be 

exploited using graphical analysis with w/(q-1) on the vertical axis and {μ(κ), λ(κ)} on the 

horizontal axis, where κ indicates the level of IPRs. The interesting regions in parameter space 

are those in which a self-enforcing contract can be written and a firm may still prefer FDI. 

The ranges of μ and λ on Graphs 1-3 reflect the relationship between these two variables. 

Consider a country with weak protection, near the right of the graph, where both FDI and 

licensing are at a high risk of losing control of the proprietary asset. Call the point where IPRs is 

low enough that λ=1 and a self-enforcing contract is no longer possible the extremum λ1. In 

addition, label the extremum μ1 as the point where any firm engaging in FDI is assured of 

 

the relative wage. 
14

imitation. I assume λ1< μ1, so that for a range of low IPRs a self-enforcing contract is not 

possible, but a firm can still have a positive probability of preserving its asset through 

internalization. 

 At the other extreme of high IPRs, call the point λ0 where λ=0 and a perfect contract can 

be written and μ0 the point where the firm faces no risk of imitation. I assume here that μ0 < λ0, 

so that for a range of high IPRs an innovating firm can obtain the full rents from a licensing 

contract but still faces the risk of imitation after FDI. The resulting range on the x-axis is μ0 < λ0

< λ1< μ1, which means that imitation encompasses a broader range than defection. These 

assumptions allow for the model to illustrate economic activity beyond the regions in which selfenforcing contracts are always possible. Appendix B considers all the possible ranges of the 

extrema. 

 These points show an inherent cost advantage for licensing in the model. For perfect 

IPRs, a licensor receives the full rents R, but a firm engaging in FDI only earns R-F. For very 

lax IPRs, a licensor earns zero rents, but the internalizing firm earns negative rents –F. This 

reflects the advantage licensors have in that they do not have to pay for a new plant and can use 

existing Southern facilities. Firms will choose to internalize only if the risk of dissipation makes 

the cost F necessary. As (13) shows, if μ = λ for any level of IPRs, a firm will always prefer 

licensing to FDI at these points. 

 A firm is indifferent between FDI and exporting when (11) holds with equality, and 

indifferent between licensing and exporting when (12) holds with equality. Define these two 

lines to be the IE line and the LE line, respectively. 

IE line: 

R

F

q q

w

+ + − = − μ 1

1

1 (14) 
15

LE line: + λ − = − 1

1

q 1 q

w . (15) 

Graph 1 displays these lines in (w, κ) space with w/(q-1) on the vertical axis and {μ(κ), λ(κ)} on 

the horizontal axis. 

w/(q-1)

q/(q-1)

1/(q-1) + F/R

1/(q-1)

μ0 λ0 μ1 λ1 μ(κ), λ(κ)

IE

LE

Graph 1: The IE and LE lines

 In the region above the IE line firms prefer FDI to exporting, and in the region above the 

LE line firms prefer licensing to exporting. The points where the IE and LE lines intersect are 

those points where (13) holds with equality. Call this the IL line. 

IL line: 

R

F λ − μ = . (16) 

This line, independent of the relative wage, captures the relationship between λ and μ that makes 

a firm indifferent between FDI and licensing. At this point, the intellectual property regime is 

such that the difference between the royalty rates paid to the licensee and the risk of imitation 

faced by an multinational firm is exactly equal to the fixed-cost disadvantage of FDI. Following 

a weakening of IPRs, if the licensing rate grows faster than the imitation rate, the left-hand side 
16

will rise relative to the left-hand side, and firms will prefer FDI to licensing. The converse is 

true if the imitation rate grows faster. 

 Graph 2 fills in the IL line and divides the space into regions of preference, labeling the 

level of IPRs for the IL line κ*. In the shaded region the firm realizes negative rents from all 

modes of entry and will choose not to produce. Since both μ and λ are decreasing in κ, strong 

IPRs regimes are located to the left of κ*. Weak IPRs regimes are located to the right of the 

graph. 

w/(q-1)

q/(q-1)

1/(q-1) + F/R

1/(q-1)

μ0 λ0 μ1 λ1 μ(κ), λ(κ)

Licensing

FDI

Exporting

Graph 2: Mode of entry

κ∗

strong IPP weak IPP

Production

No

 As can be seen, firms will prefer FDI to exporting when the protection of intellectual 

property is low, but will shift their preference to licensing as protection strengthens. The 

necessary wedge between relative wages also decreases as one moves to the left of the graph. 

This leads to the following proposition. 
17

Proposition 1: Assuming sufficiently high relative wages, firms will tend to internalize 

production if intellectual property protection is weak, and will license production if 

protection is strong. With stronger IPRs, firms on the margin of the exporting region will 

shift production abroad, and those formerly on the margin between FDI and licensing will 

choose licensing.

Proof shown in Appendix C-1. 

 The intuition for this proposition follows the fixed-cost disadvantage for FDI discussed 

above. For regions to the left of κ* in Graph 1, the relative wage necessary to induce FDI is 

higher than that to induce licensing. Consider point λ0, where IPRs is strong enough that the 

licensor can enjoy the full rents R from its contract. A firm that engages in FDI can never enjoy 

such returns, since it must always pay the fixed cost F. For all values of λ and μ near this point, 

firms prefer licensing to FDI. 

 Now consider point λ1. In this region, IPRs is so weak that a firm cannot expect to 

receive any return on a licensing contract. At point λ1, the expected return is zero. Firms that 

engage in FDI face a high risk of imitation, but can still expect some positive value to its 

production since the probability of dissipation is less than one. With such weak IPRs, firms 

prefer to internalize production. 

3.3 Industry differentiation 

The model differentiates industries according to how easily a firm’s innovation can be 

imitated by a competitor, which in turn affects their dependence on IPRs. Consider two types of 

firms in the model, C and M, differentiated by their response to IPRs. Every industry faces the 

same level of protection in the country—IPRs are not sector-specific—but may respond to this 
18

level differently. Products that embody great technological sophistication, but can be easily 

replicated, are sensitive to the level of protection. I call firms that produce these goods C firms. 

On the other hand, M firms produce goods that cannot easily be replicated and are relatively 

insensitive to IPRs levels. The products of M firms are by nature difficult to imitate, no matter 

the legal backing of intellectual property. C and M, roughly, stand for chemicals and metals, 

respectively. 

 M firms are in industries that enjoy natural barriers to imitation, and are thus relatively 

free from the threat of imitation no matter the level of IPRs. C firms, however, are in industries 

vulnerable to imitation of their latest quality innovations, and would require a higher level of 

IPRs to protect the rents from innovation. For any given value of κ, M firms have a lower 

imitation rate and must share less in a licensing contract than C firms. In Graph 2, M firms will 

be located in regions to the left and C firms in regions to the right. Firms that are less likely to 

be imitated are thus more likely to license technology, and firms at risk of imitation are more 

likely to internalize production. 

The effect of IPRs on an industry depends, in part, on the size of potential lost rents. The 

mark-up q, which reflects the value added of research and development, determines the 

magnitude of rents. For simplicity, assume both q and w are identical across industries, so the 

rents are the same regardless of the sector of production, and industry differences arise solely in 

the fixed cost F. For sector-specific differences, I assume that F represents a firm’s dependence 

on intellectual property relative to its dependence on IPRs. I consider this to be the ratio of the 

capital cost of production to the R&D cost of innovation, which essentially normalizes all firmspecific rents to the price mark-up q. 

 Industries with a high ratio of production costs to R&D costs are relatively safe from 
19

imitation. If the actual cost of production is high then the firm faces fewer potential imitators, 

since after dissipation a rival firm will find the high capital cost a barrier to entry. In addition, if 

the proprietary asset does not embody considerable technical costs, the firm faces a lower 

relative loss upon dissipation. The ratio of production costs to R&D costs are captured in this 

model by the parameter F. Since higher costs indicate natural barriers for protection, M firms 

face a higher fixed cost than C firms. 

With industry differentiation, the IE line for M firms is higher than that for C firms. The 

ensuing regions for licensing and FDI are affected, as shown in Graph 3. 

w/(q-1)

q/(q-1)

1/(q-1) + F/R

1/(q-1)

μ0 μ(κ), λ(κ)

Licensing FDI

Exporting

C

Licensing FDI

M

Graph 3: Industry differentiation

strong IPP weak IPP 

The lines of indifference for C firms are drawn in pink (filled lines), and for M firms in blue 

(dashed lines). As can be seen, for C firms FDI space grows at the expense of licensing space, 

and for M firms licensing space grows at the expense of FDI space. Since C firms are more 

affected by IPRs, they are concentrated near the right of the graph in the regions supporting FDI. 

M firms are concentrated near the left of the graph in regions supporting licensing. This analysis 
20

leads to the following proposition. 

Proposition 2: Firms that produce goods that are complex or technologically sophisticated 

will tend to internalize production through foreign direct investment. Firms that face a 

lower risk of imitation, or are less technically advanced, will tend to license production to 

non-affiliated Southern firms. 

Proof shown in Appendix C-2. 

4 Concluding remarks 

The response of individual firms to intellectual property protection depends on 

characteristics of their industries, which in turn affects the manner in which technology gets 

transferred from the innovative North to the developing South. This paper shows that stronger 

IPRs in the South lead to an overall increase in technology transfer, but may alter its composition 

from an internalized multinational firm to arms-length licensing. Proposition 1 shows that as 

IPRs strengthen, firms are more likely to shift production to the South and are more likely to 

license technology. Proposition 2 shows that firms that are technologically sophisticated will 

tend to internalize production. 

Stronger IPRs encourage firms to prefer overseas production due to the expanded 

protection on their ownership advantage. Different firms choose different modes of entry due to 

their relative sensitivity to protection. Firms with natural barriers to imitation tend to choose 

licensing, and vulnerable firms choose FDI, but stronger IPRs may cause substitution between 

these modes. Not only is there an increase in FDI and licensing with stronger IPRs, but also a 

change in the composition of technology transfer. 
21

 The different effects of FDI and licensing on the host economy are outside the scope of 

the present paper, but there are some conclusions for policymakers that can be gleaned from the 

results. Since FDI includes the development of new factories, Southern countries that desire an 

influx of capital should set an optimal policy to encourage FDI. If firms are exporting the goods, 

a strengthening of IPRs will increase the tendency of that firm to shift production to a new plant 

in the South. 

 Countries with a solid technology infrastructure, however, may prefer licensing to FDI. 

In this case, the Southern policymaker should always seek to strengthen IPRs and encourage 

firms to license their technology directly to Southern firms. As contract enforcement becomes 

perfect, most innovating firms will license their technology, regardless of their dependence on 

IPRs. 
22

References 

Aitken, Brian, Gordon Hanson, and Ann Harrison. 1997. Spillovers, Foreign Investment, and 

Export Behavior. Journal of International Economics 43: 103-132. 

Anand, Bharat and Tarun Khanna. 2000. The Structure of Licensing Contracts. The Journal of 

Industrial Economics 48(1): 103-135. 

Cohen, Wesley M., Richard R. Nelson, and John P. Walsh. 2000. Protecting Their Intellectual 

Assets: Appropriability Conditions and Why U.S. Manufacturing Firms Patent (Or Not). 

NBER Working Paper No. 7552. 

Dunning, John. 1981. International Production and the Multinational Enterprise. London: 

George Allen and Unwin. 

Ethier, Wilfred and James Markusen. 1996. Multinational Firms, Technology Diffusion, and 

Trade. Journal of International Economics 41: 1-28. 

Gallini, Nancy and Brian Wright. 1990. Technology Transfer Under Asymmetric Information. 

RAND Journal of Economics 21(1): 147-160. 

Glass, Amy and Kamal Saggi. 1997. Multinational Firms and Technology Transfer. Ohio State 

University Working Paper 97-04. 

Grossman, Gene and Elhanan Helpman. 1991. Innovation and Growth in the Global Economy. 

Cambridge, Massachusetts: The MIT Press. 

Haddad, Mona and Ann Harrison. Are There Positive Spillovers from Foreign Direct 

Investment? Journal of Development Economics 42:51-74. 

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Econometrica 61(6): 1247-1280. 

Horstmann, Ignatius and James Markusen. 1987. Licensing versus Direct Investment: A Model 

of Internalization by the Multinational Enterprise. Canadian Journal of Economics 20: 464-

481. 

Levin, Richard, Alvin Klevorick, Richard Nelson, and Sidney Winter. 1987. Appropriating the 

Returns from Industrial Research and Development. Brookings Papers on Economic 

Activity 3: 783-820. 

Mansfield, Edwin. 1994. Intellectual Property Protection, Foreign Direct Investment, and 

Technology Transfer. International Finance Corporation, Discussion Paper 19. 

Mansfield, Edwin. 1995. Intellectual Property Protection, Foreign Direct Investment, and 

Technology Transfer: Germany, Japan, and the United States. International Finance 
23

Corporation, Discussion Paper 27. 

Maskus, Keith. 2000. Intellectual Property Rights in the Global Economy. Washington, D.C.: 

Institute for International Economics. 

Markusen, James. 1995. The Boundaries of Multinational Enterprises and the Theory of 

International Trade. Journal of Economic Perspectives 9(2): 169-189. 

Markusen, James. 2001. Contracts, Intellectual Property Rights, and Multinational Investment 

in Developing Countries. Journal of International Economics 53(1): 189-204. 

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Commission Working Paper 99-11-A. 

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Smarzynksa, Beata. 2000. Composition of Foreign Direct Investment and Protection of 

Intellectual Property Rights: Evidence from Transition Economies. Mimeo, World Bank. 

Smith, Pamela J. 2001. How do foreign patent rights affect U.S. exports, affiliate sales, and 

licenses? Journal of International Economics 55(2). 

Vishwasrao, Sharmila. 1994. Intellectual Property Rights and the Mode of Technology 

Transfer. Journal of Development Economics 44: 381-402. 

Wang, Jian-Ye, and Magnus Blomström. 1992. Foreign Investment and Technology Transfer. 

European Economic Review 36: 137-155. 

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53(1): 169-188. 
24

Appendix A 

Appendix A.1 Transportation costs and non-traded goods 

For simplicity, I have assumed zero transportation costs in the main model. In this 

section, I show that including theses costs simply adds a nuisance parameter to the model. 

Reproduce the fundamental equations (1) – (3) as 

(1-μ)R – F > E (A1) 

(1-λ)R > E (A2) 

(1-μ)R – F > (1-λ)R. (A3) 

Suppose exporting firms face iceberg transportation costs τ for each good sold. The 

marginal cost for Northern production becomes wnτ, with a relative cost difference wnτ/ws = wτ. 

Rewriting the profit equations (7) and (8) 

Ls q

w E = (1 − τ )

 

(A4) 

Ls qR )

1 = (1 − . (A5) 

Thus, (10) becomes 

q

L

R E w s − = ( τ −1) . (A6) 

Plugging this into the IE line (A1) and the LE line (A2) yields 

R

F

q q

w

+ + − > − τ μ 1

1

1 (A7) 

τ + λ − > − 1

1

q 1 q

w . (A8) 

The IL line does not change. Transportation costs simply scale the relative wage upward. 
25

 Notice that some values of τ lead to the presence of non-traded goods in the model. This 

occurs if exporting is preferred to FDI and licensing (neither A7 nor A8 hold) but exporting 

yields negative rents due to the high transportation costs. If exporting yields negative rents, then 

(1 − )Ls < 0

q

w

τ ; (A9) 

thus, goods are non-traded if τ > q/w. 

Appendix A.2 Reverse engineering 

 In the main paper, I have assumed that exporting firms are free from the risk of imitation. 

This assumption, common in the literature, greatly simplifies the overall equations without 

reducing the model’s explanatory power. In this section, I show the results when considering the 

possibility of reverse engineering. 

 Suppose exporting firms face the risk of imitation m. The expected rents from exporting, 

formerly E, are now (1-m)E. The IE line from (1) can be rewritten 

(1-μ)R – F > (1-m)E (A10) 

Plugging in the profit equations (7) and (8) yields 

)

1 ( 1

1

1 −

− + + − − > − q

q w

m

R

F

q q

w

μ . (A11) 

The IE line shifts down, making firms more likely to prefer FDI to exporting. 

 Similarly, the LE line from (2) can be rewritten 

 (1-λ)R > (1-m)E. (A12) 

Plugging in for the profit equations yields 

+ λ − − > − 1

1 (1 ) 1 q

m

q

w . (A13) 
26

The LE line shifts down, making firms more likely to prefer licensing to exporting. 

 As would be expected, the possibility for reverse engineering that lowers the returns to 

exporting decreases the regions in parameter space that firms would be likely to export. An 

interesting addendum to this discussion considers the possibility that reverse engineering and 

imitation after FDI occur at the same rate, if μ = m. In this scenario, the IE line can be written 

R

F

q q

w

1 (1 )

1

1 + μ

+ − > − (A14) 

and the LE line can be written 

μ + λ − − > − 1

1 (1 )

q 1 q

w . (A15) 

The presence of μ as a variable in the denominator of the equations of these two lines makes 

Graph 3 considerably more complicated. The IE line is now increasing and convex, with the IL 

line decreasing and concave. The firm’s decision-making process, however, does not change. 
27

Appendix B The various ranges of κ

 Section 3.2 discusses the range of μ and λ used in the paper. The assumption μ0 < λ0 < 

λ1 < μ1 permits the model to discuss the regions in which FDI may take place but a selfenforcing contract may not be possible. Of the potential ranges on IPRs, this assumption best 

reflects the actual activity of firms. 

 In this appendix, I consider the other possible ranges of κ that lead to different scenarios 

in the graphs. In general, the propositions of Section 3 are robust to these different cases. I 

discuss the exceptions in turn. The following is an exhaustive list of the possibilities. 

 Case (i): μ0 < λ0 < λ1 < μ1 

 Case (ii): λ0 < μ0 < μ1 < λ1

 Case (iii): μ0 < λ0 < μ1 < λ1 

 Case (iv): λ0 < μ0 < λ1 < μ1

 Case (v): μ0 < μ1 < λ0 < λ1 

 Case (vi): λ0 < λ1 < μ0 < μ1

 The main section of the paper uses case (i). In case (ii), the range of self-enforcing 

contracts is larger than the range at which imitation of FDI is possible, just the opposite of case 

(i). As can be seen in Graph B-1, the biggest effect is a new licensing region at the right of the 

graph. 
28

w/(q-1)

q/(q-1)

1/(q-1) + F/R

1/(q-1)

λ0 μ1 λ1 μ0 μ(κ), λ(κ)

Licensing

FDI

Exporting

Lic.

Graph B-1: Mode of entry in case (ii)

κ^

 This region may tend to contradict Proposition 1, since firms in this new region will 

substitute FDI for licensing as IPRs strengthens. The point κ^, however, is that at which the 

return to FDI is exactly zero, when the probability of imitation is so high that the expected rents 

are just equivalent to the fixed cost. In the region to the right, the returns to FDI are negative, so 

a firm will prefer to write a licensing contract that at worst gives it zero rents. Although 

possible, this scenario is implausible, since a firm would unlikely license its innovation for a 

miniscule return. 

 In case (iii), the risk of imitation is always greater than the risk of defection, for all values 

of κ. A firm paying a fixed cost for FDI faces a greater risk of losing control of its asset. As 

shown in Graph B-2, firms will thus always prefer licensing to FDI. 
29

w/(q-1)

q/(q-1)

1/(q-1) + F/R

1/(q-1)

μ0 λ0 μ1 λ1 μ(κ), λ(κ)

Licensing

Exporting

Graph B-2: Mode of entry in case (iii)

 In case (iv), the risk of defection is always greater than the risk of imitation, with the 

results depicted in Graph B-3. 

w/(q-1)

q/(q-1)

1/(q-1) + F/R

1/(q-1)

λ0 μ1 μ0 λ1 μ(κ), λ(κ)

Licensing

FDI

Exporting

Lic.

Graph B-3: Mode of entry in case (iv)

κ^

 Cases (v) and (vi) are both implausible scenarios. In case (v), μ

1

 < λ0, so that for a 

particular range of IPRs a firm can write a perfect contract but faces assured imitation under 
30

internalization. In case (vi), there is a range at which a firm faces no risk of imitation but cannot 

write a feasible contract. These cases are depicted in Graphs B-4 and B-5, respectively. 

w/(q-1)

q/(q-1)

1/(q-1) + F/R

1/(q-1)

μ0 λ0 μ1 λ1 μ(κ), λ(κ)

Licensing

Exporting

Graph B-4: Mode of entry in case (v)

 

w/(q-1)

q/(q-1)

1/(q-1) + F/R

1/(q-1)

λ0 μ1 λ1 μ0 μ(κ), λ(κ)

FDI

Exporting

Lic.

Graph B-5: Mode of entry in case (vi)
31

Appendix C 

Appendix C.1 Functional Forms of μ(κ) and λ(κ) 

 The key equations of Section 3 are: 

R

F

q q

w

+ + − = − ( ) 1

1

1 μ κ (C1) 

( ) 1

1

1

+ λ κ − = q − q

w (C2) 

R

F λ(κ ) − μ(κ ) = . (C3) 

(C3) shows that firms will be indifferent between FDI and licensing if the difference in the 

disadvantages of licensing over FDI exactly offset the fixed cost of FDI. The major 

disadvantage of licensing is that it is easier to break a contract than it is to imitate at a given level 

of κ. The value of κ that sets (C3) equal is labeled κ*. 

 The regions of IPRs are bounded by the extrema (μ0, μ1) and (λ0, λ1), which are in fact 

the values of κ that solve the functions λ(κ) and μ(κ) for (0,1). That is, 

μ(μ0) = 0 (no imitation) (C4) 

λ(λ0) = 0 (perfect contracts) 

μ(μ1) = 1 (perfect imitation) 

λ(λ1) = 1 (no enforceable contracts). 

Since the functions μ(κ) and λ(κ) are negative in IPRs, the extrema have the following 

relationship: 

μ1 < λ1 < κ* < λ0 < μ0. (C5) 

This appears to be the opposite relationship than on the graphs in Section 3, but notice that the xaxis represents μ and λ, while (C5) represents relationships in κ. 
32

Consider the following functional forms for μ(κ) and λ(κ): 

λ(κ) = α - βκ (C6) 

μ(κ) = γ - δκ. (C7) 

Solving for the extrema gives 

 μ0 = α/β, μ1 = (α-1)/β (C8) 

λ0 = γ/δ, λ1 = (γ-1)/δ. 

The assumption that λ(κ) has a steeper slope than μ(κ), which allows for the space of imitable 

FDI to be larger than the space of enforceable contracts, requires that λ1 - λ0 < μ1 - μ0. This 

means that β>δ, and since λ0>μ0, we must also have α>δ. Basically, this means that λ(κ) is 

greater than μ(κ) for low values of κ, but decreases at a faster rate. For low IPRs, the royalty 

returns (1-λ) are lower than the expected value of FDI, so firms will tend to internalize 

production, but the royalty rate increases with κ until licensing dominates the fixed cost of FDI. 

 Graph C-1 shows the mode of entry in (w, κ) space. Notice that the graph is a reflection 

of Graph 2, since the x-axis is increasing in κ. 
33

w/(q-1)

q/(q-1) + 1

q/(q-1) + F/R

q/(q-1)

μ1 λ1 μ0 λ0

Licensing

FDI

Exporting

Graph C-1: Mode of entry

κ∗

κ

I can solve for κ* with these functional forms. Plug in to (C3) to get 

 R

F

α − βκ * −(γ − δκ*) = , (C9) 

which solves to 

 β δ β δ

α γ

− − −

− = F R k / * . (C10) 

Since α>γ and β>δ, κ*>0. 

 This result yields the following formal representation of Proposition 1. 

Proposition C-1: For given (w/(q-1), F/R), firms will prefer FDI to licensing if λ - μ > F/R. 

Assume the functional forms λ(κ) = α - βκ and μ(κ) = γ - δκ, where β>δ to ensure the range 

of enforceable contracts is contained within the range of imitation of FDI. Firms are 

indifferent between FDI and licensing if κ = κ*, where β δ β δ

α γ

− − −

− = F R k / * . If κ > κ*, firms 

prefer licensing to FDI. If κ < κ*, firms prefer licensing to FDI. 
34

Appendix C-2 Industry Differences 

 Since industry differences arise solely in the fixed cost F, I assume FM > FC. With the 

same functional forms as Appendix C-1, have 

β δ β δ

α γ

− − −

− = F R k / * . (C11) 

Thus κM*

 < κC

*

. This leads to the following formal representation of Proposition 2. 

Proposition C-2: For a given (w, q, λ(κ), μ(κ)), firms will prefer FDI to licensing if κ<κ*. 

Assume FM > FC to represent natural barriers to imitation. From Proposition C-1, 

β δ β δ

α γ

− − −

− = F R k / * . Thus, 0 ( )/ * * > −

− − = β δ

κ κ

F F R M C

C M . There exists a range of IPRs, κM*

< κ < κC

*

, such that if the relative wage is favorable to shifting production, then M firms 

will license and C firms will engage in FDI.