New technology, subsidies, and competitive advantage.

• Author: Chen, Zhiqi

1. Introduction

   In the history of world economic development, it is not uncommon that from time to time the role of technological leadership shifted from one country to another; a lagging country seized the opportunity of a major technological innovation and overtook the leading country. The postwar experience of the U.S. and Japanese steel industries is an example of such "leapfrogging." In 1950s, the U.S. steel industry was the world leader in technology, plant scale and productivity [2, 71]. The Japanese steel industry, on the other hand, was in its infancy. At that time two basic technologies were available for steel producers: the established open-hearth furnace and the new and more efficient basic oxygen-furnace process. The U.S. steel producers invested heavily in the open-hearth technology immediately after the World War II. Hence in the late fifties and early sixties they resisted the shift from the open-hearth furnace to the basic oxygen-furnace. The Japanese steel producers, on the other hand, had little sunk investment in the old technology. They expanded their production capacity by building brand-new plants using the oxygen-furnace technology. As a result, the U.S. steel industry gradually lost its position of world dominance after 1960s. The American share of world steel production fell from 40 percent in 1955 to 18 percent in the early 1970s [2, 69].

   It is also interesting to note the different policies pursued by the U.S. government and the Japanese government towards their steel industries during that period. The Japanese government actively promoted the growth of its steel industry by providing tax and depreciation incentives as well as low interest loans. The U.S. government, on the other hand, adopted a more or less laissez-faire approach and did not play an active role in encouraging the U.S. steel producers to switch to the new technology. The U.S. government started to intervene only after the U.S. industry had already lost its competitive advantage to Japan at the end of 1960s.

   Why did the U.S. steel industry lose its competitive advantage to Japan? Some might argue that the U.S. steel producers and the U.S. government simply made a mistake. Resisting the new technology was a strategic error on the part of the U.S. steel producers. The U.S. government also erred in not intervening earlier. This explanation, however, is not satisfactory if one believes in the fundamental assumption of economics that agents are rational.

   In this paper, instead of dismissing the decisions of the U.S. firms and government as mistakes, we attempt to understand their behavior as the outcome of interactions among rational agents. We argue that their decisions may be optimal given the economic environment they were in. The arguments go as follows. Consider the decision-making of two firms with regard to the adoption of a new technology. Suppose that one firm is in the technologically leading country and has access to an existing technology, and that the other firm is in the technologically lagging country and is starting from scratch. When the adoption of the new technology involves a large set-up cost, a firm's decision to adopt or not to adopt the new technology is based on the comparison of gains from the new technology with the set-up cost. The gains of the new technology is smaller for the firm that has access to an existing technology than the gains for the firm that is starting from scratch. Therefore, the firm in the leading country has a smaller incentive to adopt the new technology than the firm in the lagging country.

   Similarly, comparisons of costs and benefits also determine a government's decision to assist or not to assist its firms in their adoption of new technology. In an industry characterized by imperfect competition, the increased competition brought about by the entry of a more efficient firm into the industry will benefit the consumers of the product. Such pro-competitive effect, however, does not exist in the leading country when its government helps its existing firm to adopt the new technology. Subsidizing the adoption of new technology by a new firm will bring the pro-competitive benefits to consumers, but the profits of the new firm come at the expense of the profits of the existing firm in the leading country, something that the government in the lagging country does not have to worry about when it nurtures its new firms. Consequently, the government in the lagging country is more aggressive in helping its firms than the government in the leading country.

   To formalize the above arguments, a simple theoretical model is constructed. The model contains two countries, named as the U.S. and Japan. There are two goods, one is produced by competitive firms in both countries, and the other has been produced by a monopolist in the U.S. The emergence of a new and more efficient technology for producing the second good makes it possible for a firm in Japan to produce the good. The U.S. monopolist has to decide whether to switch to the new technology at the same time as the Japanese entrant decides whether to enter the industry. A key assumption of this model is that a firm has to incur a fixed set-up cost when it adopts the new technology.

   The equilibria in this model depend on the magnitude of this set-up cost as well as the efficiency of the new technology. It is shown that if the cost of adopting the new technology is within a certain range, the U.S. monopolist will continue to use the old technology as the Japanese firm, equipped with the new technology, enters the industry, hence causing a reversal in the pattern of international trade. Another interesting result is that if the new technology is a drastic improvement over the old technology, it is possible that there are two equilibria in the model. In one equilibrium the U.S. monopolist switches to the new technology and keeps the Japanese firm out of the industry; and in the other equilibrium the Japanese firm enters the industry and, by doing so, discourages the U.S. firm from adopting the new technology.

   The model is then extended to explore the possible role that a government can play in assisting its domestic firm to gain a competitive advantage over its foreign rival. Suppose that before the firms make their decisions, the governments of the two countries decide, simultaneously, whether to subsidize the adoption of the new technology. This subsidy game is studied under the following two sets of parameter values: (1) the cost of adopting the new technology is so high that, in the absence of any government subsidies, no firm will use the new technology; and (2) the new technology is a drastic innovation so that there are multiple equilibria under laissez-faire. It is demonstrated that for a range of parameter values, there is a unique equilibrium in which the Japanese government offers a subsidy to ensure the entry of the Japanese firm while the U.S. government offers no subsidy, leading the U.S. firm to retain the old technology.

   In the literature, the issue of "leapfrogging" has been studied by Brezis, Krugman, and Tsiddon [1] and Ohyama and Jones [6]. The models in both papers are based on a learning process that improves the productivity of a technology over time. The pattern of this evolution in productivity determines a country's choice of technology. In Brezis, Krugman, and Tsiddon [1], the myopia of each individual firm leads it to use the technology that has a higher current productivity, and "leapfrogging" occurs because the current productivity of the new technology is higher (respectively, lower) than that of the existing technology for the lagging (respectively, leading) country. In Ohyama and Jones [6], on the other hand, firms make intertemporal comparisons of the productivity associated with different technologies. A lagging firm overtakes the leading firm because of the (intertemporal) comparative advantage of the lagging firm in the new technology.

   Clearly, in this paper the phenomenon of "leapfrogging" in international competition is analyzed from a different perspective. The results of this paper illustrate the roles played by imperfect competition and by the set-up cost of adopting a new technology. This analysis, therefore, follows the tradition of the industrial organization literature on the adoption of new technology [5; 7; 8, 401-4]. Furthermore, the international trade framework in this paper makes it possible to analyze the governments' strategies towards using industrial policies to encourage the adoption of new technology, an analysis that is absent in the industrial organization literature. Indeed, the main contribution of this paper is that it offers an explanation to why the government of a lagging country (such as Japan in the Fifties and Sixties) may be more aggressive than the government of the leading country in assisting its domestic firms to adopt new technology.

   The paper is organized as follows. The basic model is presented in section II and the equilibria of the model are studied in section III. The subsidy game is analyzed in IV. In section V the model is extended to allow the possibility of an entrant in the U.S. Section VI is concluding remarks.

2. Basic Model

   The model presented below is simple and stylized. But it contains enough ingredients for the purpose of illustrating the main arguments of the paper.

   Suppose there are two countries in the world, named the U.S. and Japan. There are two goods named good x and good y. Labor is the only factor of production. It is assumed that the two countries have the same amount of labor endowment, i.e., L = [L.sup.*], where L ([L.sup.*]) denotes the labor endowment of the U.S. (Japan). In what follows, an asterisk (*) will be used to identify the variables of Japan.

   Both good x and good y are produced with fixed coefficient technology. Good y is treated as the numeraire good, and hence the units are chosen in such a way that one unit...