Intellectual property rights and the mode of technology transfer

JOUFtNALOF

ELSEVIER

Journal

of Development

Intellectual

44 (1994) 381402

property rights and the mode of technology transfer Sharmila

University of Kentucky,

Economics

Development ECONOMICS

Vishwasrao*

Department of Economics, 335 Business and Economics Lexington, KY 40506-0034, US,4

Received

May 1992, final version

received

April 1993

patent

protection

Building,

Abstract Transferring

technology

in an environment

where

is uncertain

can

firm’s ability to appropriate rents. This paper incorporates asymmetric information in a screening game where the innovating firm has the choices of licensing a new product at arm’s length to a foreign firm, exporting it, or licensing it to a subsidiary. Subsidiary production avoids the risk of imitation but involves higher costs for the innovating firm. The gains to the Southern country pose

significant

risks

to an innovating

from the lack of intellectual property right protection behavior by Northern firms who opt for technology monopoly production. Key words: JEL

1.

Trade related intellectual

classification:

034;

F23;

property

may be offset by strategic transfer via subsidiary or

rights; Technology

transfers

L14

Introduction

The infringement of patent rights by foreign countries can inflict significant losses on innovating firms, and alter their behavior with respect to research and development and technology transfer to the foreign country. A survey by the USITC (1988) of 736 U.S. firms, estimates aggregate worldwide losses as a result of inadequate protection of intellectual property at $23.8 billion,

*This paper is Marie Thursby, by Mike Webb, referees are also

based on my Ph.D dissertation at Purdue University. I would like to thank John Carlson, John Weinberg and Yukiko Hirao for their guidance. Comments participants at a seminar at the University of Kentucky, and two anonymous acknowledged.

0304-3878/94/$07.00 (0 1994 Elsevier Science B.V. All rights reserved SSDI 0304-3878(94)00019-9

382

S. Vishwmrao

/ Journul of Drvelopnwn~

Ecwwmics

44

( 1994) 381-402

about 2.77; of the total sales affected by intellectual property.’ The study cites 54 countries, with Brazil, India, Japan, and Mexico being the worst offenders. Recent GATT negotiations have consequently sought to bring patent protection under the purview of GATT with the objective of creating a common set of international intellectual property rights (IPRs). The issue of trade related intellectual property rights has polarized the world into developed Northern countries that conduct significant amounts of R&D and desire high levels of patent protection and Southern countries that do not. Northern governments have long argued that infringing IPRs lowers welfare for all parties concerned because of the reduction in both R&D spending and transfer of technology to countries that infringe IPRs. Theoretically the issue is not clear cut. Countries that do not undertake significant amounts of R&D have strong free riding incentives and patent protection is not necessarily welfare enhancing for a country in the South (Chin and Grossman, 1988; Deardorff, 1992).2 Exceptions may occur when R&D is highly productive (Chin and Grossman, 1988), when preferences over new technologies are different in the two regions (Diwan and Rodrik, 1991) when both regions are rivals in the R&D process (Beath, 1990) or if Northern firms undertake some defensive ‘masqueing’ action to make imitation more difficult (Taylor, 1993). The literature on patent protection and North-South trade has however largely ignored issues of technology transfer and information3 and the mode of technology transfer. All the papers cited above assume that imitation is the primary source of technology transfer to Southern countries. When information is not freely transmitted, this may not be true. Information contained in patents may lead to ready dissemination of knowledge in Northern countries, but developing countries often face the problem that the information disclosed in the patent is not sufficient to lead to profitable imitation (Bagchi et al., 1984). In such situations, it may be necessary to obtain licenses before imitation can occur, and the firm may not always be able to imitate even after licensing. An additional informational constraint affecting the problem in a North-South context, is that of selective and often biased interpretations of existing patent laws in Southern countries. Working requirements, compulsory licensing and patenting of processes can all make it difficult for Northern firms to r These estimates are sensitive to assumptions about various elasticities. Feinberg and Rousslang (1990) for instance, estimate that the lost profits for U.S. firms are only 1.8:, of total sales. * Bagchi et al. (1984) argue that unlike technology transfer arrangements between Northern countries which usually include some cross licensing of patents, arrangements with Southern countries only include the use of blueprints, trademarks etc., which allow the licenser to exploit greater monopoly profits and further lower the incentives for Southern countries to protect patents. 3 Imitation is treated as ‘unintentional’ technology transfer in Taylor (1991). Masqueing can increase the costs of imitation, but explicit transfer through licensing or FDI is not an issue.

S. Vishnusrao

1Journal of’ Drvelopmenf

Economics

44 (1994) 381-402

383

determine the degree of patent protection afforded to their technologies. I try to incorporate both these information problems in modeling the technology transfer problem in this paper. Patent infringement may provide an internalization motive for foreign direct investment.4 The innovating Northern firm can choose between licensing production to a Southern firm, exporting the good embodying the new technology, or direct investment in the form of a wholly owned subsidiary in the Southern country. If direct investment can circumvent imitation, then the lack of patent protection may impose costs on Southern countries when Northern firms respond to the uncertainty associated with patent protection by reducing arm’s length licensing in favor of subsidiary production or monopoly exports. I examine the technology transfer problem under two different scenarios, depending on whether the country allows foreign direct investment (FDI) or not. Subsidiary production allows the Northern firm to act as a monopolist in both countries and avoids the risk of imitation. These features of subsidiary production however make it fairly distasteful for Southern governments to accept FDI and so a number of countries do not allow this type of production.5 Southern countries have typically imposed numerous restrictions on FDI, ranging from nationalization to compulsory licensing and restrictions on the repatriation of profits. A government’s policy regarding FDI can be important in determining the impact of patent policy on technology transfer. While in some cases, it may make Northern firms opt for licensing, that is not always true. An example that comes to mind is the case of Coca-Cola in India. When the government insisted on licensing production, which would have involved a disclosure of the formula used to make the cola drink, and banned FDI, the American firm simply chose to leave the market. In the next section of this paper, I set up and solve the imperfect information game, when the Northern firm’s choices are restricted to exports and licensing. Section 3 explores the effects of allowing direct investment. Given this framework, the Southern country’s options regarding patent policy and FDI are examined in Section 4. I compare welfare for the South under different regimes to see whether the Southern government has an incentive to introduce patent protection. 2. A screening game While

the world

consists

of a number

of countries,

profitable

production

4Some early studies include Baranson (1970), Caves (1971) and Dunning (1979). More recent examples can be found in Horstmann and Markusen (1989) and Ethier and Markusen (1990). 5 India, Brazil, Argentina, Japan, to name a few, have all had policies which discouraged FDI in favor of licensing.

384

S. Vishwnsrao

/ Journal

of Developmen

Economrcs

44 11994)

381-402

can take place in only two of them, denoted by the North and South. There is one firm in the North that has invented a new good and holds a patent on this good or the technology used to produce it. For simplicity, assume that only one firm in each country can prolitably produce the good.(j The Northern firm has a number of options. It may choose to ‘export’ by producing the good as a worldwide monopolist, it may license production to a Southern firm alone, also referred to as monopoly licensing, it may license production to another Southern firm but also produce at home ~ multiplant licensing, or it may choose foreign direct investment by licensing production to a wholly owned subsidiary in the South. In the event that it chooses to license production, the licensing contract specifies a royalty and a lump-sum fee and both firms sell the good to an integrated world market. Patents are perfectly protected in the North but not in the South. The information contained in the patent is not sufficient for imitation in the South, so imitation is impossible unless the Southern country acquires the blueprints for production through a license.’ If imitation occurs after licensing, the Southern firm produces a perfect substitute for the licensed good and avoids royalty payments to the Northern firm.8 Imitation after licensing is not certain but occurs with some probability that is known only to the Southern firm. The Northern firm must design a licensing contract that maximizes its profits given the risk of imitation. The problem is specified as a screening game in which the Northern firm attempts to find licensing contracts that can provide information about the Southern firm’s ability to imitate. The Southern firm decides whether to accept or reject the contracts offered. The screening game thus entails the uninformed player making the first move. The choice of a screening set-up has the dual advantages of being more tractable to solve than a signaling game because it does not require complicated refinements to the equilibrium concept, and presents a more realistic picture of most technology transfer negotiations. Where the innovating firm holds the upper hand in negotiations, it is likely that they set a price for a new technology rather than entertain offers from the South.

’ A similar assumption is found in Markusen (1984) and Wright (1990a, b). It can be justified by appealing to an imperfect ability to transfer the intangibles beyond the first firm as in Markusen, or by assuming that the total costs for the industry increase with multiple plants because of rising factor costs as in Wright. ’ A similar specification of imitation is found in Gallini and Wright (1990), and Rockett (1990). Underdeveloped countries have typically had problems transferring complicated technologies to the extent that nationalization of existing plants has not always been successful. ‘There is some evidence to support this assumption. The USITC (1988) report found the most common complaint against infringing countries was that of lost revenues from royalties and licensing, cited by 73% of Firms surveyed.

S. Vishwsrao ! Journal qf Development Economics 44 (1994) 381-402

385

The subsidiary has the same marginal costs, but faces some disadvantages compared to the licensee. These disadvantages include informational costs, the risk of nationalization, and restrictions on the repatriation of profits, and will be captured by a fixed cost f. On the other hand, the Northern firm controls the subsidiary and circumvents the possibility of imitation even though production takes place in the South.’ The Northern firm chooses the optimum mode of technology transfer given these tradeoffs. 2.1. The decision structure In the first stage of the game, nature determines whether the Southern firm can imitate or not. This can be thought of as the state of technological development of the country. If the Southern country is sufficiently advanced, the Southern firm may be able to imitate the technology. The Southern firm can be one of two types. If nature allows it to imitate then the firm is of type np - it does not protect patents. If nature dictates that the technology cannot be imitated, then the firm is a type p - it protects patents. The Southern firm alone observes this move by nature. While the paper models the ability of a firm to imitate as a random move by nature, it can be alternatively interpreted as uncertainty resulting from the South’s patent policy. For instance, we can assume that firms can always imitate after licensing but the patent policy prevents imitation with probability k. A lower value for k would imply a lower probability of patents being protected. Thus the lack of a clear-cut patent policy in the South leads to uncertainty, in that Northern firms do not know whether their patent will be protected or not. If the Southern firm is of the imitating type, then the Southern firm does not honor the licensing agreement when it consists of a lump-sum fee and a royalty rate, by not paying the per unit royalty. If the South cannot imitate, then it must pay the royalty. The information contained in the patent alone is not sufficient for the country to be able to imitate so it needs to license production before imitation can take place. However, after licensing imitation is costless for the type of firm that can imitate. The Northern firm has some subjective prior probability k that the Southern firm cannot imitate the technology and will thus honor the licensing agreement. After nature has made its move, the Northern firm decides whether to license production of the good to the South or to export the good. If it decides to license the technology, it determines what the contract will be to maximize its profits. The Northern firm will thus offer a set of licensing contracts. In the penultimate stage of the game the Southern ’ Since imitation is impossible without obtaining the blueprints for the technology, to envisage a situation where even if workers change jobs they cannot successfully technology for rival firms.

it is not hard duplicate the

386

S. Vishwasrao / Journal qf Development Economics 44 11994) 381-402

t=o Stage 1

t=1

t=3

t=2

Stage 2

Stage 3

>

Stage 4

Stage 1: Nature determines

whether the Southern fum can imitate or not (known only to the Southern fm).

Stage 2: Northern firm makes license contract offers. Stage 3:

Southern fum decides whether to accept or not.

Stage 4:

If Southern firm accepts, the two firms compete as Cournot duopolists. Fig. I. The timing

of the game.

firm decides whether to accept a contract or to import the good. If the firm is indifferent, we assume that it will accept the contract. If the Southern firm does license the technology, in the final stage of the game, the two firms compete as Cournot duopolists. Fig. 1 describes the timing of the game.

2.2. Assumptions Assume that the North has a monopoly on the production of a new good that can be produced with total cost =c. q;, where q is the quantity produced by each firm, j=n, s refers to the North and South respectively. The assumption of increasing cost is common in the literature on Multinational Enterprises (MNEs). New innovations often have a ‘public goods’ characteristic that allows the technology to be transferred to additional firms at a low cost resulting in multiplant economies (Markusen, 1984; Horstmann and Markusen, 1989). We can assume that the South’s costs are lower so that the South’s costs are l/d of the North’s. Lower labor costs in the South could motivate this, for instance. Assume that d> 1 to ensure that the South’s costs are lower than the North’s. We also assume that only one firm in each country can profitably produce the good. There is a single world market with inverse demand function P = a - Q where Q = qn + qs. License contracts consist of lump-sum fees 1, and a per unit royalty Y either of which may be zero or positive. The contract offers are described by E=(/‘, ri), i=p, np, where the first term in parentheses refers to the lump-sum fee and the second to the per unit royalty for each type of Southern firm. Empirical evidence suggests that contracts with market share restrictions are against not common (Killing, 1977),” and one of the common complaints lo Out of 24 licensing agreements for current found to contain some export restrictions.

technology

that

the author

surveyed.

six were

Southern firms is that patent infringement allows them to compete at lower costs against Northern firms in world markets. Because we wish to examine cases where firms from both countries may potentially compete in a common world market. we do not allow contracts to include market restrictions.”

irzfbrmution

2.3. Complete

In this section we compare the profitability of licensing to exports, first when patents are protected, and second when they are not protected. The problem can be solved backwards starting with competition at the output stage. If patents are protected or alternatively if imitation is impossible, the Southern firm’s problem is to maximize profits Q’(r) because the royalty will always be paid:

(2)

=(n-(q.+q.)-F-r)q,.

First-order

conditions

for a maximum

are ZLl~/dqj

= 0;

problem

except

2cq

u-q,-2q,-“-r=O.

d

The Northern royalties therefore

and first-order

firm

solves

conditions

a similar

it does

pay

yield

a-2q,-2cq,-q,=O.

Solving the reaction royalty rate:

not

(4)

functions

yields Cournot

outputs

as a function

of the

d( a + 2ac ~ 2r - 2cr) 4c + 4c2 + 4cd)’

qs = 1% +

” Wright (1990b) shows that in the complete information case, contracts restrictions such that the licensee and licenser both act like monopolists markets dominate contracts with per unit royalties.

with market share in their respective

S. Vishwasrao / Journal of Development Econwnics 44 (1994) 381-402

388

(ad + 2ac + dr)

(6)

qn=(3d+4c+4cd+4c2j

Profits

for each firm are given by Q

no

= d(d + c)(a + 2ac - -~ 2r - 2~r)~ (4c+4~~+3d+4cd)~ ’

n;(rj

= (1 + c)(ad + 2ac + dr)2 (4c + 4c2 + 3d + 4cd) .

s

As can be for the South. The next participation. maximize its

seen, the royalty

increases

and Il: where

(8) Northern

profits

but lowers

profits

problem is to determine the license price subject to licensee Thus the Northern firm chooses a royalty and lump-sum fee to payoff.

max V= II:(r)

+ lp + rq,(r),

1-r subject

to

Z7: d Ip.

The best that the North can do as far as the lump-sum fee is concerned to set lp = I7,P(r) and so V= LIZ(r) + Ii’:(r) + rq,(r). Let the r so determined denoted by rp. In our example, rP=

a( 4c + 4c2 + d) (2( 1+ c)(4P+ 4cd + 4c2 + 4.

(9)

(10) is be

(11)

Second-order conditions are satisfied for all values of c and d and the optimal royalty is always positive when patents are protected and information is complete. (See Fig. 2.) Typically, the form of the licensing contract depends on the nature of the For instance, with constant marginal innovation and the cost structure.12 costs, if the innovation is a new product with no existing substitutes, then production would only involve one firm because monopoly production is more profitable. The technology might be licensed to a lower cost Southern firm if the Northern innovating firm could commit to staying out of the market. If, however, the innovation is a reduction in the cost of producing an existing good (a process innovation), then production would be licensed to a

” Dasgupta and Stiglitz (1980), Gilbert and Newbery (1982), Katz and Shapiro (1985), Rockett (1990), and Gallini and Wright (1990), to name a few, have all explored different aspects of this problem.

S. Vishwasrao

I Journal of

Development

Economics

44 (1994)

381-402

389

l(r) Royalties Fig. 2. Determining

the optimal

royalty

rate.

competing firm as long as it was possible to charge a per unit royalty. In this paper, we have the case of a product innovation that can be produced with increasing marginal cost technology. Increasing marginal costs lead to multiplant production being more efficient. Given that only one firm in each innovating firm is better off country can produce the good, l3 the Northern licensing production to a competing firm, as long as it can appropriate the Southern licensee’s profits. In this setting, the royalty serves to reduce output market competition between the two firms. Differentiating the royalty rate with respect to d reveals that as d increases, the optimal royalty decreases. The royalty rate falls as the cost difference between the two increases because the optimum allocation of production dictates that the lower cost producer should produce more of the good given that the Northern firm can appropriate all its profits as payment for the license. Patent protection allows the Northern firm to take advantage of lower multiplant production costs, because a royalty can be used to reduce the output market competition. Proposition equilibrium

1. The fill information with multiplant licensing.

game with patent protection

has a unique

Proqf Exporting involves the Northern firm producing alone. Because of the assumption that the Southern firm has lower production costs, exporting must be inferior to licensing the Southern firm alone and extracting

I3 Without this assumption, clearly in this case it would be profitable to license to more than two firms in the South and pose an additional contractual problem in that the firm always has an incentive to license more firms later, similar to the situation faced by a durable goods monopolist.

S. Vishwasrao

390

/ Journal qf’Deveiopmeni

Economics

44 (1994)

381-402

monopoly profits with a lump-sum fee and cannot be an equilibrium outcome. If monopoly licensing to the South were optimal, then the royalty rate would be zero. As can be seen from Eq. (1 l), r is always positive, and so monopoly licensing cannot be an equilibrium. Thus multiplant licensing is the only possible outcome. Q.E.D. When the South does not protect patents, different contracts will be offered to the two types of firms, p and np. The type p contract will be the same as the full information, patent protection case because the Northern firm knows that imitation is impossible. If the Northern firm licenses production to the type np firm, one that imitates, it can, at best, sell the license for a lump-sum fee alone and appropriate the Southern firm’s profits as the fee. This, as we can show, will not always result in multiplant licensing. Once again the choices available to the North are exports, multiplant licensing, and monopoly licensing. The strategy for the Northern firm is to simply set the royalty equal to zero and license the technology for a lumpsum fee alone because the imitating Southern firm avoids the royalty payments after licensing. With multiplant licensing, the Northern firm’s duopoly profits in this case are nE(r=O) = Ll:p, and the Southe;n firm’s profits are &(r=O) = IT:!‘. The contract Cp is (nzp, 0). The payoff to the Northern firm is the sum of both firms profits, HE*+ LIEp. The payoff from exporting is IIF, and monopoly licensing yields l7$, with the license contract specifying (I= Up, Y= 0). Monopoly licensing always dominates exports because of the South’s lower production costs. Proposition production

2. does

Licensing always occurs even without patent protection, hut not always involve two plants. The contract for the type p sets

Lp=(l =&?, r=rP). The type npjirm’s contract can he monopoly licensing Lnp = (I= ITT, r = 0) or multiplant licensing with Lnp = (1 = Ii’:“, r = 0). There

are two cases

that need to be considered.

Case 1. If‘ c > c’ then Hip + Ilyp > Lip and multiplant outcome. Case II. Ifc-cc"then brium outcome. Proof.

See Appendix

with

Ll~P+Il~P
and

licensing

monopoly

is the equilibrium

licensing

is the equili-

A.

The inability to charge a royalty, results in a trade off for the North. For a given d, if c is small enough then the loss to the North from increased output market competition outweighs the gain from multiplant production. Recall that a smaller c reduces the slope of the marginal cost curve, and the

S. Vishwasrao / Journal

qf Development Economics 44 (1994) 381-402

391

problem becomes similar to the constant marginal cost situation. In this case, monopoly licensing is clearly better. In addition, as d - the South’s cost advantage - increases, the range of c for which monopoly licensing to the lower cost firm is optima1 also increases.r4 Clearly in the full information case without subsidiary production, the Southern government’s incentives to enforce patent protection depend on the form of the licensing contract to the type np firm. Since the Southern firm does not retain any profits, welfare depends on consumer surplus alone. The worst outcome from a welfare perspective is monopoly licensing because the firms do not exploit the economies of multiplant production. Multiplant licensing with royalties improves on monopoly licensing for the same reason. However the best outcome is multiplant licensing without royalties because not only do the consumers enjoy the benefits of lower production costs, the lack of a royalty increases output market competition and lowers prices even further. A welfare maximizing Southern government’s incentives to protect patents thus depend on the costs of production. If ccc’, then not protecting patents leads to monopoly licensing for the type np firm, and the South would be better off protecting patents. If c>c’, then not protecting is optimal because it allows the Southern firm to obtain licensing contracts without royalties. In the remainder of the paper I consider primarily the case where multiplant licensing occurs regardless of imitation, and discuss the effects of very low cost technologies on the equilibria of the game.

2.4. Incomplete

infbrmation

To solve the incomplete information game, we need to find the subgame perfect Nash equilibria. Because the uninformed Northern firm moves first in setting the price for the license, the Southern firm’s actions do not affect its beliefs. This eliminates the need for Bayesian updating and Nash equilibrium describes the game adequately. The Southern firm is fully informed and so has no beliefs to update given the Northern firm’s strategy. The strategy set for the North consists of license contract offers I!!’ and Pp. Each contract specifies a lump-sum fee and a per unit royalty. After the Northern firm has offered the license contracts, the Southern firm decides whether to accept and become a licensee, or reject the contracts and import the good. k is the prior probability that the Southern country is type p. We can look for two genera1 solutions - a separating solution and a pooling solution. ‘* This is similar to a Katz and Shapiro (1985) result, in which they show that when only a fixed fee can be charged, only one firm will produce in the market if the difference in the two firms’ marginal costs is large enough.

392

S. Vishwawao

/ Journal

qf Development

Economics

44 (1994)

381-402

A

Payoff to North

;

Pooling

n, i Monopoly

0

Fig. 3. Payoffs

k*

1

from different

strategies,

k’

c>c’.

A pooling contract specifies a royalty rate and a lump-sum fee that is acceptable to both types of Southern firms, where the royalty and lump-sum fee are selected to maximize the North’s expected profits from licensing. The Northern firm collects lump-sum fees as well as per unit royalties when the Southern firm protects patents - with probability k, and with probability (1 -k) only gets the lump-sum fee. The Northern firm’s problem is to: max k[fl,P(r) + rqs(r) + l] + ( I1.r

subject

to

k)[L’ip + 11,

1
(12)

(13)

Note that the type p firm always makes fewer profits than the type np firm because it must pay a royalty, and so the fixed fee that the North can charge is constrained by the type p firm’s profits. Proposition 3. There are multiple pooling equilibria that depend on the beliefs k. A pooling contract (I*, r*(k)) with O
Proof.

See Appendix

on k, if

c>c’.

B.

If the Northern firm believes that there is a high probability that the royalties will be paid, it is better off with a pooling contract with a positive royalty. As the probability of imitation increases, the Northern firm trades off the royalty (which may not be paid), against the lump-sum fee (which can be obtained with certainty). For very small values of k, the objective function places more weight on maximizing the South’s profits. This yields the corner

S. Vishwsrao

1 Journal

qf

Development

Economics

44 (1994)

381-402

393

A

Payoff to North

: :

j

i

i

;

k’l

0 Fig. 4. Payoffs

j :

from diflerent

strategies

b k

when c < c’.

solution with r* = 0. The payoff to the North from the pooling equilibrium is described in Fig. 3 for c > cl. the payoff with the pooling contract does not dominate For ccc’, monopoly profits for all k. For k= 1, the pooling contract is an equilibrium, but the Northern firm will be better off with monopoly licensing rather than multiplant licensing for k=O. Thus there exists some k for which monopoly licensing is an equilibrium. In this case, the licensing contract will set (I= l7,“, r = 0). See Fig. 4 for a description of the payoffs. For existence of a separating equilibrium we require that the self selection constraints and the incentive compatibility constraints should be satisfied for each type of Southern country. After the Northern firm has offered a set of contracts, a separating equilibrium requires that each type of Southern firm pick a different contract, thus revealing its type to the North. Licensee participation requires that lnp < HFp( r = 0),

(14)

Pf

(15)

n:(r).

Constraints (14) and (15) will hold with equality when the Northern firm is maximizing profits. The problem in finding a separating equilibrium is that the np type firm has an incentive to accept any contract offered to the type p firm. Consider a contract (l=@(r), r). This is acceptable to both types for all values of r. If the Northern firm offers any lump-sum fee I = Q’(r) < ntp(r = 0), the np type will accept because it stands to make positive profits because duopoly profits without the royalty are greater than duopoly profits with a royalty. The only way to induce both firms to reveal their type is to charge a lump-sum fee I= 17fP(r =0) and to charge a positive royalty rate. The type p

394

S. Vishwasrao

/ Journal of Developmenr

Economics

44 (1994) 381-402

will not be able to afford this contract because when r>O, II:(r) < This results in an adverse selection outcome where the type p firm cannot afford the contract and the type np firm is the only one that will license the good. In equilibrium, no royalty will be paid. Is this an optimum strategy for the Northern firm? We need to show that for some beliefs about k, there is no other strategy that leaves the country as well off. The expected payoff with the separating strategy is given by k(Z7:) + (1 - k)(Z7:p+ nip). If the separating contract (I = nzp, r > 0) is offered, and k= 1, then the technology is not licensed since the type p firm cannot afford the contract. The Northern firm then ends up being a monopolist with no takers for its technology. The pooling contract clearly dominates the separating strategy for any positive value of k, and the Northern firm is indifferent between pooling and separating for k=O. Thus the separating strategy is an equilibrium only for k=O, namely if the Southern firm can imitate with certainty. In Fig. 3, for k> k*, pooling with the contract contract has (Q’(r*), r*) is an equilibrium, and for 0
&‘“(r=O).

r*=O.

If c < c’, then the separating strategy payoff is always less than or equal to the monopoly payoff. For k> k’ in Fig. 4, it would thus be dominated by pooling. For small values of k, monopoly profits are higher. The decision faced by the Southern firm is simply whether to accept or reject the contract offered by the Northern firm. Since the alternative is to import the good at monopoly world prices, licensing is a preferred alternative even though the licensee firm’s payoff is such that it is indifferent between licensing and not. We assume simply that zero profits are sufficient to induce licensing.

3. Licensing with subsidiary production The effect of allowing subsidiary production is that the Northern firm has the opportunity of establishing a wholly owned (or more than a 50% equity share) firm in the South. We assume that since the Northern firm owns the subsidiary, the subsidiary cannot imitate. The subsidiary acquires the technology in the same way as a licensee might, by paying a lump-sum fee and some royalty if it is indeed optimal for the Northern firm to charge such a royalty. I maintain the same assumptions as before. In the subsidiary case however, imitation does not occur after licensing and thus the firm has a clear incentive to seek subsidiary production rather than arm’s length licensing. The disadvantages of subsidiary production - not being able to utilize the existing infrastructure of a domestic firm, the need to establish a reputation, and the lack of knowledge of a foreign market - all conspire against

S. Vishwasrao / Journal of Development Economics 44 (1994) 381-402

395

subsidiary production. An example is the experience of Boots, a pharmaceutical firm from Britain, choosing to license the production of ibuprofen to Upjohn in the U.S. because of the marketing and sales advantages enjoyed by Upjohn. Upjohn marketed ibuprofen very successfully under the brand Motrin. When Boots eventually chose to enter the U.S. market and tried to compete with Upjohn, using its own brand Rufen, it could not gain a large market share in spite of lower prices (Contractor, 1985). These disadvantages can be summarized by a fixed cost f. There is a trade-off between the two options. While arm’s length licensing avoids the fixed costs incurred by the subsidiary, using a subsidiary eliminates the risk of imitation and allows the Northern firm to monopolize world production. The effect of allowing subsidiary production is simple. The Northern firm will maximize joint profits of the subsidiary and its own production, and determine the royalty rate and lump-sum fee accordingly. The Northern firm’s problem is to maximize joint profits, fT7,= (a - Q)(q, + q,) -(c/d)qg cq,’ -,f. There is no need for a royalty here because the two firms are no longer competing against each other. The optimal contract would thus set the royalty equal to zero and the lump-sum fee equal to the profits of the subsidiary firm. Proposition 4. In the full information cuse with putent protection, licensing or subsidiary production can he un equilibrium of the game.

multiplant

Proof We can solve for the range of f for which subsidiary production is an optimal response by simply comparing the payoffs from the two strategies. Multiplant licensing yields a payoff to the North of I7:+ rq, + &‘, while FDI yields profits determined by the joint profit maximization problem less the fixed cost 1‘. The total collusive profits from FDI are given by ll, = (a’( 1 + d))/(4( 1 + c + d)) -,f: In the complete information scenario with patent protection, for ,f >,f’=(a2d2c)/(4(1 +c)(l +c+d)(4c+4c2+d+4cd)), licensing is preferred to direct investment. For a low value of the fixed cost, the optimal choice for the Northern firm is to opt for subsidiary production. Q.E.D

Collusive profits for the two plant monopolist with increasing costs are always higher than profits with licensing with a royalty. When the fixed cost f is zero then clearly the Northern firm has no incentive to license the technology and will always prefer subsidiary production. If we compare profits from licensing with subsidiary production with positive fixed costs then the results will depend on the size of the fixed costs. For f large enough, the payoff from arm’s length licensing can be higher than the payoff from subsidiary production. In the complete information case with no patent protection, the np type of

396

S. Vishwasrao / Journal of Development Economics 44 (1994) 381402

licensee may not pay royalties licensing with zero royalties without royalties is lower than licensing even if f is relatively occurs in the absence of patent from monopoly licensing and Proposition 4 still applies.

and the Northern firm compares payoffs from and FDI. Since the payoff from licensing the payoff with royalties, FDI is preferred to large. If c is low such that monopoly licensing protection, then the firm compares the payoff FDI. If the Southern firm is a type p, then

Proposition 5. In the fill information case without patent protection, multiplant licensing without royalties or subsidiary production can be equilibrium outcomes if c > cl. If c CC’, then monopoly licensing or subsidiary production can be equilibrium outcomes. Proof: When patents are not protected, the choice is between multiplant licensing without royalties, monopoly licensing, or FDI. For c < c’, the payoff to the Northern firm from monopoly licensing is greater than profits from multiplant licensing with zero royalties, but less than subsidiary profits with f =O. Thus if f is small, FDI will be preferred. If c>c’, Multiplant licensing with zero royalties will yield higher profits than FDI for large values of f, but FDI is more profitable when f is small. The value of f for which FDI is preferred is higher without patent protection, than with, because the gains from licensing are lower when royalties cannot be charged. Q.E.D. If information is incomplete, we would have to compare the payoff from the pooling equilibrium (or monopoly licensing depending on costs) to the payoff from FDI. As the probability of imitation increases, it lowers the expected payoff from arm’s length licensing and makes FDI more attractive. This can be seen in Fig. 3. Fig. 3 denotes the case where f is such that multiplant licensing dominates FDI when patents are protected (k= 1). If the probability of imitation is higher (k is small) then FDI dominates licensing.

4. Welfare comparisons In this paper, the Southern government’s decisions regarding FDI affect its policy concerning intellectual property. Where patent policy is concerned, the government can choose between strictly enforcing patent rights or not enforcing them. However a lack of patent protection, unlike in Chin and Grossman (1988) does not necessarily exclude the possibility of licensing technology since imitation is not possible without licensing and so at least a fixed fee can be extracted from the licensee. Patent policy is irrelevant when imitation itself is impossible. When the Southern firm is capable of imitation, the existence of IPRs can induce a different kind of licensing contract and can also influence the choice between licensing and FDI.

S. Vishwwao

/ Journul of Developmenr

Economics

44 (1994) 381-402

397

When does the Southern country gain from weak patent protection? If information is complete, then firms in the South are indifferent between all outcomes since the Northern firm successfully extracts all profits as payment for the license. Welfare comparisons can thus be made on the basis of consumers’ surplus alone.’ 5 Asymmetric information has no qualitative effect on the conclusions. However, the type np firm stands to profit from asymmetric information when the pooling contract specifies a positive royalty because it gains from imitation unlike the complete information case where all its profits are used in acquiring the license up front. The essential trade off between patent protection and infringement remains the same. A weak patent policy may induce the Northern firm to specify licensing contracts without royalties. On the other hand, in the absence of patent protection, it may opt for monopoly licensing or FDI. The best outcome from a Southern perspective is the multiplant licensing contract without royalties followed by multiplant licensing with royalties, FDI, and monopoly licensing respectively. FDI is preferred to monopoly licensing because firms can exploit multiplant economies in production and thus world output is higher and prices lower with FDI. As long as weak patent policy does not push the Northern firm into choosing monopoly licensing or FDI where it would have chosen multiplant licensing in the presence of patent protection, the South will not opt for a strong system of patent protection. The incomplete information case differs only in that the merits of a pooling contract are compared with monopoly licensing and FDI. Recall that the pooling contract tends to charge a lower royalty and higher lump-sum fee, the greater the probability of imitation and so the full information multiplant licensing contracts are special cases of the pooling contract. The Southern government’s incentives to protect patents thus depend on the costs of production and the fixed cost of FDI. There are two separate cases that need to be examined that depend on the cost of the technology. If production costs are low (ccc’), then in the absence of patent protection, the Northern firm would find it optimal to choose monopoly licensing instead of multiplant licensing. In this case the Southern population is forced to pay monopoly world prices for the good embodied in the technology. Clearly in this case, the Southern country is made worse off by a policy of not protecting patents. World prices are higher and output lower than with the multiplant licensing which occurs in the presence of patent protection. Northern consumers, Northern firms and R&D are also adversely affected in this instance. In this case the incentives

I5 Bardhan (1982) compares a Southern country’s welfare from imports, subsidiary production, and licensing - where licensing occurs with tied inputs under different market conditions. The market structure in this paper is however different from the three market structures considered in that study.

398

S. Vishwasrao 1 Journal of Development Economics 44 (1994) 381-402

to protect patents are unaffected by the feasibility of FDI. For small values of f, the South’s patent policy is irrelevant. Even if it were to protect patents, the Northern firm would still opt for FDI. For intermediate values of f, the North might choose FDI instead of monopoly licensing in the absence of patent protection, either of which is worse than the multiplant licensing which results when patents are protected. The case where the technology is not very low cost (c >c’), so that multiplant licensing occurs in the absence of patent protection, is more interesting because of the potential gains to the South. This paper suggests that a Southern government can use patent policy strategically to induce a favorable outcome. Weak patent protection induces the Northern firm to opt for a licensing agreement which forgoes some royalties in favor of an up front fee that it obtains with certainty. This benefits consumers since lower royalties result in lower world prices. The policy on intellectual property, cannot however, be treated independently of the policy on FDI in this case. If the fixed costs of FDI are small the policy of not protecting patents could cause the Northern firm to instead choose FDI with its attendant monopoly pricing schemes. For large values of f, FDI is relatively expensive and the Northern firm would prefer licensing even if the Southern country did not protect patents. For such values of f, the Southern government might profitably continue with the policy of patent infringement. Because of the uncertainty associated with the payment of royalties, the Southern firm obtains the technology with a contract that specifies a lower royalty and a higher fixed fee, which is preferred by Southern consumers. There is an intermediate range of the fixed cost f, for which the policy conclusions are not as clear cut. For instance, consider a fixed cost f such that, with patent protection, licensing with royalties is preferred to FDI, but licensing without royalties is worse than FDI. The Southern government is worse off with weak patent policy because it makes FDI more attractive. The inability of the Northern firm to extract rents from the Southern firm through royalties offsets, to some extent, the disadvantages of FDI. Even if the fixed cost is large, it may still opt for FDI instead of licensing. In general, when the Northern firm can credibly threaten to opt for FDI, it is not always optimal for the Southern country to allow patent infringement. Another policy option that is sometimes feasible is to ban FDI altogether. Here this is an optimal response for high cost technologies, because it forces the Northern firm to lower royalties in favor of lump-sum fees. Since the North prefers multiplant licensing even without royalties, some technologies may be licensed without royalties if patents are not protected. If the technology is low cost then the effect of banning FDI would be to drive the Northern firm to monopoly licensing. Monopoly licensing is worse than FDI from a welfare perspective because production costs are higher since the firm

S. Vishwasrao / Journal qf‘ Development

Economics 44 (1994) 381-402

399

cannot exploit the economies of multiplant production. We can also treat k as a decision variable for the South. If we assume that the Southern firm can always imitate after licensing, but that patent policy can prevent imitation with probability k, then the problem for the South is to pick k to maximize welfare. As can be seen from the preceding policy discussion, whether the government would set k = 1 (protect patents) depends on the fixed costs of FDI and the relative costs of production in both countries. For instance, for c > c’ and a large f, k would be just large enough to make licensing attractive, but not drive the Northern firm to use a subsidiary. This suggests that the best policy for the South involves a case by case approach. However, as the Coca-Cola example shows, it is an approach that is not always successful. 5. Conclusion The lack of intellectual property rights protection in Southern countries can affect the nature of licensing contracts as well as the mode of technology transfer. This paper examines these choices in a partial equilibrium, game theoretic setting. By introducing asymmetric information the model seeks to capture some of the problems inherent in dealing with patent regimes where selective and biased enforcement of existing provisions accompanies the lack of protection. The paper yields some policy prescriptions as well as some testable predictions. A lack of patent protection can adversely affect licensing of low cost technologies to the South. For higher cost technologies there are some benefits to Southern countries from patent infringement. However, strategic behavior on the part of Northern firms can erode these gains to Southern countries. In this paper, patent infringement may cause Northern firms to opt for subsidiary production or monopoly licensing which lowers Southern welfare. Excluding patentability by statute will not have the desired effect unless accompanied by restrictions on FDI. The theoretical model suggests that the effect of patent infringement on the mode of technology transfer would be to cause the foreign firm to try to internalize this cost by opting for FDI rather than arm’s length licensing. There is some empirical evidence to support this prediction. Contractor (1980) finds that technology transfer through subsidiaries is more common in developing countries. While his study does not examine the differences in patent regimes, the division along developed and developing countries is analogous to the division among Southern and Northern countries regarding patent protection. Regarding the form of the licensing contract, the model suggests that for countries where patents are not protected, licensing arrangements should consist of up-front lump-sum fees rather than contracts that specify royalties in addition to such fees.

S. Vishwasrao

400

/ Journal of Development

Economics

44 (1994) 381-402

In the interests of simplicity the paper abstracts from a number of issues that may be relevant. For instance, R&D, the age and efficacy of the technology, and reputation, may all have significant implications for the conduct of patent policy. In the context of this model, R&D would be adversely affected by patent infringement to the extent that the innovating firm cannot appropriate all the rents from licensing. Once the technology exists however, the adverse effects on R&D would not influence the mode of technology transfer. Reputation may be incorporated in this model as affecting the beliefs k. If a country has a reputation for not protecting patents, Northern firms may be inclined to write contracts without royalties, opt for FDI, or monopoly licensing. More important for the conduct of patent policy is perhaps the assumption that profitable production can only take place in one foreign country. In reality, we may find that there are numerous countries where production could be licensed, albeit at a higher marginal cost, and thus the countries that do not protect patents may lose licensing contracts to countries that do protect patents. Appendix A: Proof of Proposition 2 To show that there exists some c for which zIInp+ z7”P s > Ilm ”

SY

we need to only show that for some values of c and d profits from monopoly licensing to the South are lower than the sum of duopoly profits. Subtracting the profits from monopoly exports of the good and licensing without royalties, we can find c such that l7:P+ 17:p-Il~>0. The lowest value for d is if the two firms are identical which occurs when d = 1. For d = 1, the condition can be rewritten as 8c3 + 12~’ + 2c- 13 0. There is only one positive root for c for which this condition holds with equality, c=O.2071 and for all c>O.2071, the sum of duopoly profits is greater than monopoly profits. While the analytical solution for the problem is complicated, we can numerically show that this value for c is not independent of what happens to d. As d increases, production in the South becomes increasingly profitable, and the gain from multiplant production is not high enough to outweigh the losses from output market competition. For instance if d =2, c/=0.55, and for d = 3, c’ = 0.97.

Appendix B: Proof of Proposition 3, the pooling equilibrium The Northern

firm’s problem

is to maximize

the expected

profits

from a

S. Vishwasrao 1 Journal of Development Economics 44 (1994) 381-402

contract (I, r) offered constraint:

to

max k[n$r) + rq,(r) 1-r

subject to

both

+ l(r)]

types

of firms

subject

to

a participation

+( 1 - k)[IIEp + I(r)],

I(r) d L’:(r).

Assuming that the participation constraint holds with grouping terms that depend on r, the Northern firm’s problem max k[fli(r)

401

equality, is to

and

+ rq,(r)] + L’:(r).

Let (I* =Ll,P(r*), r*(k)) problem.

describe

the

pooling

contract

that

solves

this

r* = [4acd + 12ac’d + 8ac3d + 4ad2 + 12acd2 + 8ac2d2 - 8acdk - 16ac’dk - 8ac3dk - 5ad2k - 12acd*k - 8ac2d2k]J [2(4cd + 8c2d + 4c3d + 4d2 + 8cd2 + 4c2d2 - Scdk - 16c’dk - 8c3dk - 5d2k - 13cd’k - 8c2d2k)]

For k = 1, this is the familiar full information solution with r = rp. However, as k decreases, the objective function is not well behaved because the Southern firm’s profits are not concave in royalties. There is a range of k for which r* is positive. r* > 0 only if k’
For those values of k, the pooling contract specifies a positive royalty and lump-sum fee. The optimal r increases as k increases in that range and equals rp when k= 1. However, to find the k for which this is an optimal contract we need to compare the payoff with this contract to the payoff from a zero royalty contract. For k = k’, for instance, the expected payoff for the North with this contract is less than the payoff if r = 0. This occurs because if r = 0 the payoff obtained by the North is certain and not subject to some loss from imitation. At k= 1 on the other hand we know that the payoff from (I(r*), r*) is better than (l(r), r=O). There is therefore some k*>k’ for which the optimal contract is (l(r*), r*).

402

S. Vishwasrao

/ Journal of Development

Economics

44 (1994) 381-402

References Bagchi, Amiya Kumar, Parthasarthy Banerjee and Uttam Kumar Bhattacharya, 1984, Indian patents act and its relation to technological development in India: A preliminary investigation, Economic and Political Weekly, Feb. 18, 287-304. Baranson, J., 1970, Technology transfer through the international firm, American Economic Review 60, 435440. Bardhan, Pranab, 1982, Imports, domestic production, and transnational vertical integration: A theoretical note, Journal of Political Economy 90, no. 51. Beath. John, 1990, Models of technological competition for the analysis of intellectual property rights and the Uruguay Round, Working paper for CEPR/NBER International Seminar on International Trade. Caves. R.H., 1971, International corporations: The industrial economics of foreign investment, Economica 38, l-27. Chin, Judith C. and Gene M. Grossman, 1988, Intellectual property rights and North-South trade, Working paper no. 2769 (NBER, Cambridge, MA). Contractor, Farok J., 1980, The composition of licensing fees and arrangements as a function of economic development of technology recipient nations, Journal of International Business Studies, 4762. Contractor, Farok J., 1985, Licensing in international strategy: A guide for planning and negotiations (Quorum Books, London). Dasgupta, Partha and Joseph Stiglitz, 1980, Uncertainty, industrial structure, and the speed of R&D, Bell Journal of Economics 11, l-28. Deardorff, Alan V., 1992, Should patent protection be extended to all countries, Economica 59, no. 233, 35-51. Diwan, Ishac and Dani Rodrik, 1991, Patents, appropriate technology, and North-South trade, Journal of International Economics 30, nos. l/2. 2747. Dunning, J.H., 1979, Explaining changing patterns of international production: In defense of the eclectic theory, Oxford Bulletin of Economics and Statistics 41, no. 4, 269-295. Feinberg, Robert M. and Donald J. Rousslang, 1990, The economic effects of intellectual property right infringements, Journal of Business 63, no. 1, Part I, 79-90. Gallini. Nancy and Brian Wright, 1990, Technology transfer under asymmetric information, Rand Journal of Economics 21, no. 1, 147-160. Gilbert, Richard J. and David M.G. Newberry, 1982, Preemptive patenting and the persistence of monopoly, American Economic Review 72, 514526. Horstmann, Ignatius and James R. Markusen, 1989, Licensing versus direct investment: A model of internalization by the multinational enterprise, Canadian Journal ofEconomics 20, no. 3,464481. Katz, Michael L. and Carl Shapiro, 1985, On the licensing of innovations, Rand Journal of Economics 16, no. 4, 504520. Killing, J.P., 1977, Manufacturing under license, The Business Quarterly, 22-29. Markusen, James R., 1984, Multinationals, multi-plant economies, and the gains from trade, Journal of International Economics 16, 205-226. Rockett, Katherine, 1990, The quality of licensed technology, International Journal of Industrial Organization 8, 559-574. Taylor, Scott M., 1993, TRIPS, trade, and technology transfer, Canadian Journal of Economics 26, no. 3, 6255631. United States International Trade Commission, 1988, Foreign protection of intellectual property rights and the effect on U.S. industry and trade, USITC Publication 2065, Feb. Wright, Donald J., 1990a, International technology transfer with an information asymmetry and endogenous research and development, Working paper no. 138 (The University of Sydney, Sydney). Wright, Donald J., 1990b, International technology paper no. 139 (The University of Sydney, Sydney).

transfer

and

per unit

royalties,

Working