Shall the Northern optimal R&D subsidy rate inversely respond to Southern Intellectual Property Protection?

• Author: Lin, Hwan C.

1. Introduction

   Innovative research and development (R&D) is key to technological advances and long-run growth. A central question is whether or not a decentralized economy only sustains a socially suboptimal level of investment in R&D, as was early recognized in the industrial organization literature (e.g., Dasgupta and Stiglitz 1980). To resolve this ambiguity, many empirical productivity studies based on neoclassical growth models find that knowledge spillovers are present and R&D's social rates of return considerably exceed its private rates. (1) So underinvestment in R&D does prevail in reality.

   These earlier findings largely conform to recent studies using R&D-based endogenous growth models. Jones and Williams (1998, p. 1119), for instance, estimate that "optimal R&D investment is at least two to four times actual investment." (2) By simulating a calibrated R&D-based endogenous growth model without so-called "scale effects," (3) Jones and Williams (1999, p. 2) further find that "in the absence of taxes and subsidies, the decentralized economy underinvests in R&D, with the primary impetus coming from the surplus appropriability problem." Thus, after knowledge spillovers were found to be present and significant in earlier productivity studies, the main force promoting underinvestment now is found to be the monopoly pricing of innovative goods that prevents innovators from appropriating the entire consumer surplus associated with these goods.

   Governments often subsidize R&D investment in advanced countries (North). In fact, the World Trade Organization (WTO) already completed a framework enabling governments to establish--free from counteractions by other countries--certain subsidy programs aimed at promoting R&D activities of firms, other than helping disadvantaged regions and protecting the environment. (4) It is common that Northern innovations are frequently pirated by low-cost developing countries (South), depending on their enforcement of intellectual property protection (IPP). It is therefore important to ask how the North should adjust its socially optimal R&D subsidy rate in response to Southern IPP standards. Indeed, the North has long striven to extend stricter IPP into the South under the GATT/WTO framework. Yet, as Helpman (1993) concludes, it is never in the South's interest to strengthen IPP. This conflict-of-interest problem had affected North-South relations from time to time. Other studies in the recent IPP/innovation literature include Chin and Grossman (1990), Diwan and Rodrick (1991), Deardorff (1992), Taylor (1993, 1994), and Grinols and Lin (2002). (5,6) But these studies are not aimed at addressing the plausibility of whether the North's socially optimal R&D subsidy rate tends to decline when Southern IPP standards are raised.

   In the present paper we examine this plausibility problem using a familiar North-South trade model that was developed along the line of Krugman (1979), Dollar (1986), Jensen and Thursby (1987), Grossman and Helpman (1991c), and Helpman (1993). In the model, imitative activity is viable in the low-wage South but not in the high-wage North, whereas innovative activity is active only in the North. The rate of product innovation is endogenously determined by profit-driven research inputs but the rate of product imitation is parameterized by Southern IPP standards.

   Using comparative static analysis, I find that Southern IPP and Northern R&D subsidies are not substitutable in keeping up the North's long-run innovation rate. This finding is not surprising. On the one hand, strengthening IPP serves to decrease the imitation rate, prolong the expected duration of monopoly power, free up less Northern resources from old goods production to support R&D, and thereby decrease the innovation rate. (7) On the other hand, reducing Northern R&D subsidy rates serves to increase innovation costs and thereby also decreases the innovation rate. Hence, substitutability does not hold true in the North-South framework.

   More striking are the findings from our numerical simulations. First of all, our simulation results indicate that the North's socially optimal R&D subsidy rate may either positively or negatively correspond to Southern IPP standards, depending on the elasticity of demand for innovative products. If the demand is more elastic, a tightening of Southern IPP is found to induce the self-interested North to increase the optimal subsidy rate. Conversely, if the demand is less elastic, a tightening of Southern IPP is found to invite the North to decrease the optimal subsidy rate, as one's intuition predicts. Note that Jones and Williams's (1999) numerical simulations single out the surplus appropriability problem as the main force promoting underinvestment in R&D, as mentioned earlier. Here my simulation results further show that demand elasticity, which inversely measures the degree of monopoly power and the surplus appropriability problem, can determine whether or not the Northern optimal R&D subsidy rate inversel y corresponds to Southern IPP standards.

   The market mechanism accounting for our above simulation results involves complicated opposing forces. First, a loosening of Southern IPP can increase the pace of imitation and can relocate more Northern production sites to the low-cost South while also spurring innovation, as my comparative analysis indicates. Faster innovation then brings more product varieties generating welfare gains to both the North and South. But faster innovation requires higher saving rates, thereby hurting Northern welfare at the same time. If the demand is more elastic, product differentiation is less significant and thus the beneficial product varieties effect and other effects tend to be dominated by the adverse saving effect. In this case, to respond to laxer Southern IPP, the self-interested North must decrease the subsidy rate to discourage R&D investment, slow down product innovation, and mitigate the adverse saving effect. This certainly implies that if the demand is more elastic, the North may need to increase the subsidy rate when the South strengthens IPP.

   Another important finding from my numerical simulations concerns welfare implications. I find that Southern welfare declines but Northern welfare rises at the steady state, as long as Southern IPP is strengthened. This finding once again highlights the stark North-South conflict of interest, as was earlier formalized by Helpman (1993) in which the North does not subsidize R&D at all. Further, I find that worldwide welfare maximization requires a regime of Southern IPP that is neither as stringent as the North favors nor as lax as the South prefers. This finding appears robust to the elasticity of demand for innovative goods.

   Section 2 outlines a North-South model of Krugman-Grossman-Helpman type. Section 3 analyzes substitutability between IPP and R&D subsidies, respectively, with respect to steady-state innovation rates and Northern utility maximization. This section heavily relies on numerical simulations when I attempt to compute the North's optimal R&D subsidy rates, given various standards of Southern IPP. Concluding remarks are given in section 4.

2. The Model

   We formulate the world to consist of an innovating region (North) and a noninnovating region (South). In both regions labor is the only factor of production and is inelastically supplied. We let regional labor endowments and other structural parameters combine to mimic a North-South environment in which labor wages are lower in the South than in the North. All goods are invented in the North, for only Northern producers engage in R&D. Since enforcement of intellectual property rights (IPR) is imperfect in the world, Northern innovations are to be pirated or imitated over time by low-cost Southern producers. Interregional trade thereby occurs with the North exporting pricy innovative goods in exchange for cheap imitated goods from the South. The North-South trade model laid out below is along the line of Krugman's (1979) seminal paper and the ensuing works, such as Dollar (1986), Jensen and Thursby (1987), Grossman and Helpman (1991a), and Helpman (1993). (8)

   Innovation and Imitation

   In the North many identical firms devote labor services to R&D. The flow of innovation, n(t), from research and development activities at time t is determined by

   n(t) = [L.sup.N.sub.I](t)/a/n(t) (1)

   where an overdot indicates a time derivative of a variable throughout the paper, [L.sup.N.sub.I] represents labor services devoted to R&D, n is the number of products or the stock of knowledge formerly invented in the North, and a denotes a parameter inversely measuring research productivity. Thus a/n(t) measures the instantaneous labor requirement per innovative product and implies the effect of "learning by doing" or "intertemporal knowledge spillovers." As knowledge accumulates (increase in n), a/n(t) declines and labor becomes more productive for next-generation innovations. The innovation rate g in terms of Equation 1 is

   g(t) = n(t)/n(t) = [L.sup.N.sub.I](t)/a (2)

   The way we endogenize the innovation rate is the same as in Romer (1990), Grossman and Helpman (1991b, c), and Helpman (1993), where g is linearly related to research inputs. (9) Thus, intertemporal knowledge spillovers do not peter out as knowledge accumulates over time and the equilibrium allocation of Northern labor between manufacturing and research determines the equilibrium innovation rate.

   Knowledge of manufacturing innovative goods is under global IPR protection. Such protection is imperfect, however. As time passes, Southern labor will eventually learn to produce imported goods by dismantling and studying them (i.e., so-called "reverse engineering"). Such learning or imitating costs less than does innovating and enables low-cost Southern producers to underprice their Northern rivals. (10) This gives rise to North-South trade, with the South exporting imitated...