MNE Activities: Do Patent Regimes and Host Country Policies Matter?
Usha Nair-Reichert
and
Rod Duncan
School of Economics
Georgia Institute of Technology
Atlanta, GA30332-0615
April 2002
Revised January 2003
This basic goal of this research is to examine the extent to which the host country policy environment matters when thinking about the effects of stronger IPR protection. It analyzes the impact of stronger patent protection on the MNE’s exports, local affiliate sales and licensing by explicitly modeling the joint nature of the MNE’s decision making process in servicing a foreign market. The key findings support the idea that the policy environment in the host country influences the impact of stronger IPRs on U.S.MNE activities during the period 1991 to 1997. We find that patent protection increases local subsidiary sales and reduces licensing. High R&D in the foreign markets is positively associated with both U.S. unaffiliated exports and licensing. However, in countries that pose a weak threat of imitation, stronger patent protection leads to a reduction in both exports and licensing. Patent protection in high-risk countries reduces local sales and increases licensing. The study also indicates that the marginal effect of stronger patent rights on U.S. unaffiliated exports, local affiliate and licensing varies considerably in magnitude and direction, depending on whether the economy is open or closed.
JEL Classification: Q10, Q17, F23, K33, O34.
Key words: patent protection, intellectual property rights, imitation, innovation, exports, affiliate sales, licensing, R&D.
Address for correspondence: Usha Nair, School of Economics, Georgia Institute of Technology, Atlanta, GA 30332-0615; Tel: (404) 894-4903; Fax: (404) 894-1890; E-mail:
We would like to thank Janusz Mrozek, and the participants at the Mid-West Trade meetings at Urbana-Champagne and the Emory Trade Workshop for their useful comments and suggestions, and Pat Mizak for valuable research assistance.
MNE Activities: Do Patent Regimes and Host Country Policies Matter?
- Introduction
In recent years, intellectual property rights (IPRs) have become increasingly significant in many types of international transactions, and strengthening intellectual IPRs has become a key issue in global trade negotiations.[1] The basic goal of this paper is to address the following question: to what extent does the host country policy environment matter when thinking about the effects of stronger IPR protection? A review of the literature suggests that previous empirical work on the impact of IPRs has focused largely on the monopoly and market expansion effects of stronger IPRs and analyzed how the imitative capabilities of the country influence the impact of stronger IPRs. The literature does not provide unconditional arguments regarding the impact of stronger patent rights on trade, foreign direct investment (FDI), and licensing. In particular, host-country specific collateral factors, which often affect the impact and economic value of patent rights, have been largely overlooked in the empirical literature on IPRs.[2] As Maskus (1999, pp. 6) pointed out “it is inadequate to analyze the implications of IPR systems without also considering their position in the general regulatory structure.”
There are a large number of theoretical models that assess the impact of intellectual property protection on MNE activities in the host country, but the results of these models vary a great deal and are specific to particular modeling assumptions. In Lai’s model (1998), stronger IPRs will lead to higher FDI if the imitative ability of host countries is sufficiently small, otherwise stronger IPRs could lead to lower FDI. Glass and Saggi (1999) suggest that stronger IPRs could induce resource scarcity in host countries and crowd out FDI.
There are a few theoretical models that consider the interactions between the host country environment and intellectual property protection in assessing the impact of stronger IPRs on MNE activities in the host country. In Dunning (1988) polices that enhance human capital formation may increase the threat of imitation and output competition in foreign markets, resulting in greater internalization through FDI and less licensing. Vishwasrao (1994) uses a strategic partial equilibrium model to argue that lack of patent protection may encourage FDI relative to licensing where there are country-specific fixed costs of establishing a subsidiary in the host country. For example, subsidiary production faces certain inherent disadvantages such as the fear of expropriation and other political and economic risks. The “tariff jumping” argument for FDI suggests that tariff and non-tariff barriers to trade can result in increased FDI and lower exports. Bhagwati et. al. (1992) argue that the policy framework in the host country can be endogenous to FDI.[3] Host country polices that severely restrict FDI may lead to greater licensing and exports for a given level of patent protection, while polices that enhance human capital formation may increase the threat of imitation and output competition in foreign markets, resulting in greater internalization through FDI. Rodrick (1991) suggests that “even moderate amounts of policy uncertainty can act as a hefty tax on investment, and that otherwise sensible reform may prove damaging if they induce doubts as to their permanence.” Lall (1997, p.244) also offers an interesting perspective that a strong IPR regime may be interpreted as a signal regarding the government’s overall attitude towards foreign investments and commercial activities.
Empirical evidence on the impact of IPRs is also rather diverse.[4] Despite the importance of the host country policy environment in explaining the impact of patent rights on trade, investment and technology flows, there is very little empirical evidence in this regard. Most of the existing work has focused either on the interaction between IPRs and human capital / technological capability or the openness of the economy to trade. For example, Gould and Grubin (1996) find the impact of IPRs on growth slightly stronger in more open economies. Maskus and Penubarti (1995) find a strong market expansion effect in their empirical analysis of the relation between manufactured exports from OECD countries and the strength of patent rights in developing countries. Yang and Maskus (1999b) find support for their hypothesis that stronger patent rights attract larger volumes of licensed technology and that the impact is stronger for arms length transactions. Smith (1999) using US state level export data finds substantially finds that weak patent rights are a barrier to US exports in countries that pose a strong threat of imitation. Smith (2001) where cross-sectional data for 1989is used to analyze the impact of stronger IPRs on US unaffiliated MNE exports, local subsidiary sales and licensing receipts of subsidiaries from unaffiliated firms indicates that strong patent rights increase US affiliate sales and licensing, particularly in countries with strong imitative abilities. Related research also suggests that the level of IPR protection itself varies, depending on the technological capabilities of the host countries. In short, there has been relatively little evaluation of patent rights in conjunction with other international and domestic policies to assess their full impact on the host country.
Saggi’s (1999a) comprehensive review of the literature on international technology transfer also has pointed out that most of the literature discussed suffers from another fundamental problem; either FDI or licensing is the only channel through which the Northern firm can produce in the South. A more sophisticated analysis of the consequences of strengthening patent rights in the South requires that we consider all of the MNE’s options (trade, FDI and licensing) jointly. Most of the existing empirical studies, with the exception of Maskus (1999) have not adequately captured the joint effects of MNE activities, as they are based on single equation studies, cross sectional analysis, or time-averaged data.
This research develops a theoretical framework and empirically evaluates the interactive effects of multiple institutions and polices, including IPRs protection on MNE activities. It investigates the role of the host country policy environment and its impact on the influence of stronger IPR protection in facilitating the process of internationalization of technology transfer, investment, and trade. The analysis uses a simultaneous equation framework to account for the fact that the decision by a firm to export a patentable product is jointly determined with decisions to service the market through licensing or FDI, as was done in Horstmann and Markusen (1987) and also Maskus (1998)).
Our results lend support to the argument that changes in patent rights policies should be evaluated in conjunction with other international and domestic policies to assess their full impact on the host country.The key findings indicate that the policy environment in the host country influences the impact of stronger IPRs on U.S. MNE activities during the period 1991 to 1997. We find that patent protection increases local subsidiary sales and reduces licensing. High R&D in the foreign markets is positively associated with both U.S. unaffiliated exports and licensing. However, in countries that pose a weak threat of imitation, stronger patent protection leads to a reduction in both exports and licensing. Patent protection in high-risk countries reduces local sales and increases licensing. The study also indicates that the marginal effect of stronger patent rights on U.S. unaffiliated exports, local affiliate and licensing varies considerably in magnitude and direction, depending on whether the economy is open or closed.
The rest of this paper proceeds as follows. Section 2 presents the basic model and the propositions that are being tested. Section 3 presents the empirical analysis and section 4 summarizes the key conclusions and policy implications.
2.Theoretical Framework
This section develops a framework to examine how the host country policy environment and patent protection jointly affect the MNE’s mode of entry into a foreign market through exports, FDI or technology licensing to the host country.[5] The assumptions of the model are similar to those in a standard North-South framework. An MNE in the North invents a new technology or good and patents it. Production for the Southern market can take place in the North or the South. The Northern firm has three choices or modes of production: it can produce at home and export to the South, it can form an affiliate in the South to service that market, or it can license its technology to a Southern firm. Although firms typically produce for both their domestic and export markets, we assume in this model that all production in the North is for export and that all production in the South is for the local market.
The decision of a Northern firm about the mode of production will depend on several factors in the host country. A unit of production, x, requires one unit of labor, at a cost of w in the North and ws in the South. Southern labor is assumed low cost, w > ws, and production in the South avoids the per unit tariff, t. However the decision to produce in the South will incur either a given fixed costs, f, for setting up a local affiliate or must share profits with a Southern licensor at some rate, 1-.
An important factor in the host country is the technological sophistication of local firms and labor. We assume technological sophistication is related to the level of research and development conducted by local firms, R. Technological sophistication is assumed to improve productivity of Southern labor and so lower the per unit cost of production, ws(R)/R < 0. Technological sophistication is also assumed to increase the imitative ability for new technologies by local firms. As in Fosfuri (2000) an increase in the imitative ability of local firms raises the bargaining power for Southern firms in a licensing agreement with Northern firms. This increase in bargaining position will lower the share of profits in the licensing agreement which can be captured by the Northern firm, /R <0.
The Northern firms face an inverse demand function for their output in the Southern market, p = a-bx, where p is the price and x represents quantity. xe, xf and xl represent the quantities under each of the three modes of servicing the market: exports, FDI, or licensing. The Northern firm makes a profit of e by exporting, a profit of f from opening an affiliate in the host country, and l by licensing its technology to the foreign firm.
In the case of exports, the Northern firm’s profits will be
Differentiating with respect xe, and solving for the equilibrium profits from exports, we get,
In the case of FDI, the Northern firm’s profit function is:
The equilibrium profits from FDI are
The third approach to servicing the Southern market is by licensing the technology to local firms in the host country. The division of rents between the Northern firm and the Southern firm depends on several factors such as the relative bargaining powers of the contracting parties, degree of market competition and government intervention (Contractor and Sagafi-Nejad, 1981). Several papers (Yang and Maskus (1999) and Taylor (1994) and Markusen (1997)) indicate that stronger IPRs lead to a reduction in the licensors’ monitoring and contacting costs and raise the return on transferring technology. There is also evidence in the literature that stronger IPRs increase the licensor’s share of rents. Gallini and Wright (1990) show that where information is asymmetric and imitation is possible, the licensor sacrifices some of the rent, although the licensor’s share increases with the increase in imitation costs.
In our model, we follow Yang and Maskus (1999) and Fosfuri (2000) and assume that the licensor’s rent share is a positive function of Southern IPRs. Stronger IPRs make it more difficult to imitate, and hence the licensee commits not to imitate at a lower rent share, thus increasing the licensor’s share.
Let be the Northern firm’s share of rents, such that 0<<1, =(k, R), and /k >0, where k measures the strength of the Southern IPR regime and R the level of domestic research and development. Hence the Northern firm makes a profit of (k, R)sl by licensing technology to the Southern firm, where sl is the profits of the Southern firm.
The Southern firm’s profit function can be written as follows:
The equilibrium profits of the Southern firm are:
Hence, the equilibrium profits of the Northern firms from licensing its technology to the Southern firm is
The profitability of each mode of operation for the Northern firm is not observable. However we can observe indicators of the level of operation of each mode by all Northern firms in a host country. The relative profitability of the three modes of MNE operation given by Equations 2, 4 and 7 will determine the aggregate level of operation of each mode in a host country. Holding all else constant, an increase in the profitability of one mode should raise the level of operation of that mode and lower the level of operation of the other two modes. For a higher level of tariffs for example, we would expect to see a lower level of exports and higher levels of FDI and licensing.
Applying the logic from the previous paragraph to Equations 2, 4 and 7, we derive the expected signs of the changes in the aggregate level of operation of exports, FDI and licensing for the parameters of interest from our model: k, ws, t, f and R. These expected signs are reported in Table 1. We are interested in deriving empirically testable propositions about the impact of patent protection and country specific fixed costs on the MNC’s mode of entry, and this will be the main focus of our analysis henceforth.
Proposition 1:Our modelsuggests that higher levels of patent protection will be associated with lower levels of exports and FDI and higher levels of licensing.
The literature also suggests that there may be additional effects of stronger patent protection (other than those predicted by our theoretical model) on exports, local affiliate sales and licensing which may offset each other and make the impact of patent protection on MNE activities ambiguous. Stronger patent rights create a trade off between enhanced market power and the resultant lower MNE output (monopoly power effect), and larger effective market size in the host country that results from tighter constraints on the local firms’ abilities to imitate (market expansion effect).[6] Hence, the overall effect of patent rights on trade and local affiliate sales is ambiguous and depends on the relative strengths of these effects. Yang and Maskus (1999b) argue that the overall effect of stronger IPRs on licensing and innovation is also indeterminate because of two opposing effects of patent rights: the economic returns effect that results from an increase in the share of the licensor’s rents and lowers enforcement costs, and the monopoly power effect.
Proposition 2: Greater country risk will be associated with higher levels of exports and licensing and lower levels of FDI.
In addition, we are also interested in analyzing how country specific fixed costs modify the relationship between IPRs and the MNCs mode of entry. We derive some second order results that are presented using graphical intuition.[7] Taking f and δ as our parameters of interest and holding all other parameters fixed (and dropping the function notation for simplicity), we can implicitly solve for the values of f and δ that equalize profits for the MNE under exports, Equation 2, and profits under FDI, Equation 4. As δ does not appear in either expression, this equation reduces to a critical value for f, f*:
This equation is graphed as Line 1 in Diagram 1. For fixed costs above f*, it is more profitable for the MNE to export than it is to engage in FDI. For fixed costs below f*, the reverse is true.