R&D policies, trade and process innovation

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Abstract

We set up a simple trade model with two countries hosting one firm each. The firms invest in cost-reducing R&D, and each government may grant R&D subsidies to the domestic firm. We show that it is optimal for a government to provide higher R&D subsidies the lower the level of trade costs, even if the firms are independent monopolies. If firms produce imperfect substitutes, policy competition may become so fierce that only one of the firms survives. International policy harmonization eliminates policy competition and ensures a symmetric outcome. However, it is shown that harmonization is not necessarily welfare maximizing. The optimal coordinated policies may imply an asymmetric outcome with R&D subsidies to only one of the firms.

Introduction

This paper has two main purposes. The first is to explore the relationship between trade costs and R&D investments. We show that increased integration (lower trade costs) may increase both private and social incentives to invest in R&D, and may lead firms to sell more both domestically and abroad. The second purpose is to study the effects of policy competition and cooperation in imperfectly competitive international markets, and in particular to show that R&D subsidies may in fact reduce the number of product varieties in the market. This turns out to be true both if the subsidies are set in a policy game between governments maximizing domestic welfare and if the governments set R&D subsidies cooperatively to maximize aggregate welfare.

These results are developed in a simple two-country model with trade costs, where each country hosts one firm. The firms produce horizontally differentiated goods, and can invest in process-improving R&D to reduce marginal production costs. Freer trade between the countries implies that the size of the market increases, making it profitable to invest more in cost-reducing R&D. Thereby marginal production costs and consumer prices fall. Other things equal, this leads to more export as well as higher sales at home. The latter implies that the social value of any given R&D investment then increases, due to higher domestic consumer surplus. Trade liberalization thus induces the government to increase the subsidy level. It should be noted that the motive for R&D subsidies is not to promote exports per se; the size of the export market is important only because it matters for the choice of R&D investments and hence for consumer surplus at home.1

In addition to the consumer-surplus motive for subsidizing R&D, there is also a strategic motive for active R&D policies when firms from different countries produce (imperfect) substitutes. This strategic (‘business stealing’) motive may give rise to policy competition between the countries. Contrary to many previous studies we find that policy competition does not necessarily result in too high subsidies; it may, however, lead to unstable or asymmetric equilibria. The determining factor in our model is the degree of product differentiation. If goods are close substitutes, policy competition may be so fierce that it is impossible for both firms to survive in the market. Depending on the degree of product differentiation in the industry, we may thus have a stable symmetric equilibrium, an unstable symmetric equilibrium, or no symmetric equilibria at all. In the latter two cases there may exist stable asymmetric equilibria where one firm monopolizes the market (and the other firm is inactive), even if the countries and the firms at the outset are completely symmetric.

The outcome of the competitive policy game is suboptimal from a global point of view. Hence, there is a need for R&D policy cooperation that takes into account profit and consumer surplus in both countries, and eliminates policy competition. Coordination of R&D policies may be particularly relevant within closely integrated regions where the use of other policy measures to support domestic industry is already regulated. Based on e.g. actual and proposed tax reforms in the EU, a natural approach could be to require that R&D subsidies are harmonized between the countries. If the countries harmonize their R&D subsidies to a common level in our context, the outcome where one firm monopolizes the market is avoided. Somewhat surprisingly, this is not necessarily welfare maximizing. If the two goods are sufficiently close substitutes, it will not be optimal from society's point of view to invest in process innovation in both firms. Hence, the optimal cooperative R&D policy for the two countries could be to subsidize R&D in one of the countries, but not in the other. In fact, it may even be optimal to tax R&D in the other country. The intuition is that the consumers do not gain very much from having access to different varieties if the goods are close substitutes. So to avoid duplication of the investment costs, the first-best cooperative policy could be to stimulate R&D in one firm and reduce the R&D incentives in the other.

Little research has been done on the links between trade liberalization and R&D policies. In particular, we are not aware of any other studies showing how trade liberalization may increase private and social incentives to invest in R&D, leading firms to sell more both domestically and abroad even in absence of strategic interactions. However, starting with Spencer and Brander (1983), there is a large literature focusing on the business-stealing motive for subsidizing R&D. This focus can partly be explained by the fact that international agreements prohibit the use of, for instance, pure export subsidies. In such settings Neary and Leahy (2000) emphasize the important point that R&D policies may be a second-best option to support domestic firms in international markets. Moreover, Bagwell and Staiger (1994), Brander (1995) and Leahy and Neary (2001a) have found that R&D subsidies can be a more robust instrument than export policies. It should be noted, though, that these studies typically abstract from consumer-surplus effects and make the simplifying assumption that all production is exported to a third market. This strand of literature thus argues that policy competition tends to result in excessive R&D from the subsidizing countries' point of view.2

D'Aspremont and Jacquemin (1987) initiated a wave of research that analyzes the consequences of R&D cooperation between firms that compete in the end-user market. Both D'Aspremont and Jacquemin and later studies have found that this kind of cooperation may be welfare improving and increase industry profit.3 However, Salant and Shaffer, 1998, Salant and Shaffer, 1999 and Amir and Wooders (1998) point to the fact that these studies presuppose that the firms choose the same level of R&D and sell the same quantities, while the optimal solution may actually be asymmetric.4 In particular, Salant and Shaffer (1999) deal with the fact that it may be optimal to treat ex ante identical agents unequally if there is Cournot competition in the product market. Hence, the symmetric equilibria identified in the literature may not represent optimal outcomes. Leahy and Neary (2004) relate the results from Salant and Shaffer to the question of whether the second-order conditions for a symmetric equilibrium are satisfied, and discuss more generally how to interpret the results regarding symmetric versus asymmetric outcomes.

Our analysis relates to this recent line of literature in its emphasis on the possibilities of asymmetric equilibria. However, we focus on competition or cooperation at the policy stage, whereas Leahy and Neary (2004) and most of the other studies look at R&D cooperation between firms and abstract from subsidization issues.5 Moreover, the existing literature typically assumes Cournot competition with homogeneous products. An important exception is Collie (2002), who analyzes welfare effects (inclusive of consumer surplus) of providing production subsidies to imperfectly competitive firms in an economic union. He shows that production subsidies under policy competition is welfare enhancing if and only if the firms produce sufficiently differentiated goods. This result is consistent with our findings, and indicates that the welfare effects of granting subsidies is relatively robust with regard to what kind of subsidies we consider, but depend crucially on how close substitutes the firms produce. Apart from considering different kinds of subsidies, there are three main difference between Collie's paper and ours. First, we consider asymmetric equilibria. Second, we include trade costs and analyze the effects of trade liberalization. Third, while Collie focuses on production subsidies, we allow firms to invest in R&D. The output of R&D – here more cost-efficient production technologies – is a non-rival good that should be provided in a greater quantity the larger the activity level of the firm. The latter is the reason for our result that it is optimal even for a government which only maximizes domestic welfare to grant higher R&D subsidies to a monopoly the lower the level of trade costs.6

Section snippets

The model

Demand side

We employ a model with two intrinsically symmetric countries and two firms. Firm 1 is located in and owned by residents of Country 1, while Firm 2 is located in and owned by residents of Country 2. The population size in each country is equal to 1, and the utility function of a representative consumer is given byUi=αqii+αqji(qii22+qji22+bqiiqji),where qii and qji are consumption of the goods produced by the domestic and the foreign firm, respectively. The first subscript thus

R&D policies with intra-industry trade

In the rest of the paper we assume that b  (0, 1), which means that the two goods are imperfect substitutes. It should be noted that the standard quadratic utility function described by Eq. (1) has the realistic feature that total market demand is decreasing in b, all else equal.8 This reflects the common assumption that consumers have convex

Concluding remarks

In this paper we study optimal industrial R&D investments in an international setting. First, we show that trade liberalization generates more R&D, more sales, possibly also in the domestic market, and higher R&D subsidies. The policy effects do not rely on any business-stealing motive; even for a monopoly it would be the case that optimal R&D subsidies and domestic sales increase when trade costs go down.

Second, we study in some detail policy competition between two governments pursuing their

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A previous version of the paper has been presented at the Sixth Annual Conference of the European Trade Study Group (ETSG) at the University of Nottingham, September 2004, and at the Hitotsubashi Conference on International Trade and FDI, October 2004. We would like to thank participants at these conferences for very valuable comments; in particular, our discussant at Hitotsubashi, Sadao Nagaoka.

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