Intellectual property rights: An international economics perspective

Review of Industrial Organization 6: 247-267, 1991 0 1991 Kluwer Academic Publishers. Printed in the Netherlands.

Intellectual Property Rights: An International Economics Perspective

MARTIN RICHARDSON* Department of Economics, Georgetown University, Washington DC 20057, U.S.A.

(Received: April 1990; revised November 1990)

Abstract. This paper considers the enforcement of intellectual property rights in an international setting. I consider some of the traditional problems associated with protection of such rights in a closed economy and discuss complications added by an international dimension. Globally-optimal and nationally-optimal policies are compared. A simple model of policy choices is derived and optimal tax/subsidy and rights enforcement policies demonstrated. The paper concludes with a brief discussion of the current U.S. approach of discriminatory treatment on the basis of the national origin of an infringing product and argues that it is inferior to subsidies for providing incentives for R&D and to tariffs for shifting profits to U.S. firms.

Keywords. Intellectual property, international economics.

1. Introduction Intellectual property refers to the intangible products of

research, innovation, creativity and commercial reputation.

[Intellectual property] is typically protected by patents, trade

marks, trade secrets, copyrights and other laws covering

proprietary technical data. (USCC, 1988, p. 39.)

There are a number of well recognized problems associated with either the production of intellectual property (IP henceforth) - i.e. research and development (R&D) - or its dissemination (see, e.g., Spence, 1984). First, there are certain natural monopoly features of R&D industries and, consequently, the standard economic problems of any decreasing-cost industry. Efficient marginal-cost pricing may not cover total costs; more efficient output may involve either under- or over- entry into the industry. A second feature special to IP is that the output of knowledge may not be perfectly appropriable by its producer - non-payers cannot be fully excluded - due to its intangible nature, and this provides a disincentive to undertake R&D. It is on this last point that I concentrate but all of these aspects of IP have complex interactions.

This paper explores these considerations in an international setting to investigate how they are changed, if at all, when some of the appropriating firms are foreign

248 MARTIN RICHARDSON

and they sell to domestic consumers. Is there a case for discriminating between domestic and foreign firms and, if so, in what circumstances and in what fashion? How might nationa2ty optimal policies compare to globally optimal ones? The paper concludes with an analysis of the current U.S. approach in this area as embodied in 9337 of the U.S. Tariff Act of 1930 (amended by the Omnibus Trade and Competitiveness Act of 1988.)

The paper is organized as follows. Section II provides a brief survey of some relevant economic literature in the area of R&D and spillovers, from a primarily closed economy perspective. Section III develops a simple model of R&D and discusses a number of complications that arise in an open economy, arguing that various conflicting effects make it impossible to say, a priori, whether a market- determined level of R&D will exceed or fall short of the socially desirable level. So we may not wish to encourage innovation generally. This section also discusses whether or not innovation by domestic firms is to be preferred, from a strictly national perspective, to innovation by foreign firms, concluding that there are indeed circumstances where it is preferred. These cases stem from the possibility of shifting pure profits from foreign firms to domestic ones and so are fraught with the now-familiar problems of all strategic trade policy. I also conclude that there will only be a case for preferring domestic infringement to foreign for similar profit-shifting reasons if the infringers themselves make pure profits.

Section IV then analyzes 9337 of the U.S. Tariff Act of 1930, and recent amendments, in this earlier framework, and briefly discusses alternative ap- proaches to correcting R&D incentives. The recent strengthening of 9337 is in- terpreted as providing stronger protection against infringement by foreign firms than against infringement by domestic firms. This position is consistent with Bar- ton’s argument (1989) that $337 disadvantages imports in a way that is not necessary to protect U.S. IP rights and thus violates GATT. Thus, the focus here is on the issue of differential treatment of infringers, not on the correct level of IP rights enforcement. To conclude that $337 is undesirable is not to conclude that IP protection in the U.S. is too strict, for example, but rather that there may be no case for differential effective treatment of infringers. The perspective taken in this Section is one of purely U.S. national interest. The ambiguities of policy arising from the earlier discussion make a compelling case that a globally efficient system of IP rights can only be achieved through international coordination and so any unilateral approach such as $337 is easy to dismiss as a very poor policy from a global perspective. However, I argue that $337 is poor policy even from a selfish, purely national viewpoint. If its purpose is to encourage innovation then not only is appropriability a poor tool (a system of subsidies is better) but the asymmetric treatment of infringers is unwarranted. If its purpose is to shift profits from foreign to domestic infringers (hence the asymmetry) then it is inferior to a system of tariffs or other such restrictions.

I conclude that not only may tightening appropriability be undesirable per se but also that discriminatory treatment of infringers will generally not be optimal

INTELLECTUAL PROPERTY RIGHTS 249

in any case. Such treatment may be desirable in some circumstances, but it is argued that there are better ways to restrict infringement than tightening appropriability in such circumstances. A final section summarizes and concludes.

2. Economic Issues of IP in a Closed Economy

Suppose production of IP were just like production of any other good save for the incomplete appropriability aspect. Such a model - where spillovers’ occur to other firms - can give misleading conclusions. Incomplete appropriability would lead to underinvestment in IP-generating activities, and this distortion would most directly be corrected by tightening appropriability itself, although a corrective subsidy would do the job just as well. This approach, however, captures neither the complications mentioned earlier other than inappropriability - zero marginal costs and imperfect competition - nor certain other important complications. A deterministic production function for IP output is not compelling: more realistically, the production of knowledge is an uncertain function of research, albeit with the probability of success increasing in the level of inputs. Further, the output of R&D firms is necessarily differentiated and full appropriability thereby generates monopoly power. This is not the case when production of IP is just like production of widgets except that a firm cannot claim all of its output. In that approach, full appropriability and perfectly competitive markets are compatible - anybody can produce widgets - but with IP appropriability by definition precludes

production by others. There may be competition at the R&D stage while there is monopoly power once an innovation is made. This points up a final important distinction between the production and dissemination of IP.

A more realistic specification of the production of IP is one wherein there is a fixed cost associated with establishing an R&D project and then recurrent costs over time as long as the project continues. The probability of success in any period is an increasing, concave function of each of these costs. In a model of this nature, corrective policy is not a priori obvious and depends on the relative importance of a number of conflicting effects. To the extent that there are spillovers (e.g. from non-appropriability) firms have an underincentive to pursue R&D from society’s viewpoint. But as each firm endeavours to be successful in the race to innovate, it lowers the expected time to completion of the project overall. For other firms, then, the value of success at any time is lower, as it is more likely that they have been preceded and this is a negative externality ignored by firms in choosing their levels of investment. This is the crowding or common-pool effect to which Dixit (1988b) refers2 and it tends to lead to over-investment in R&D from society’s viewpoint. The optimal policy to correct these assorted externalities involves trading them off against each other and may involve either a subsidy or a tax depending on which effect dominates.

Assuming we know whether R&D should be encouraged or discouraged, however, Dixit notes that the appropriate vehicle of optimal policy is to increase or


decrease the reward to succeeding rather than to tax or subsidize one of the inputs to R&D as the latter induces substitution between inputs and consequently an added deadweight loss. Although Dixit does not consider a policy of increasing appropriability alone, it is straightforward to deal with. In his model, the private value of success is capitalized to a present value P and the spillover benefit to the rest of the economy to a value S. The firm ignores the latter in making its R&D decisions. One can consider a policy of increased appropriability as one which raises P with an offsetting fall in S. Total social benefit is unchanged by this, so the socially optimal level of R&D is also unchanged, but the incentive for a firm to do R&D is now increased. Whether this is desirable or not depends whether we wish to increase or decrease R&D, of course.

By supposing that the private and social benefits of an R&D success can be capitalized into given sums, however, the Dixit model suppresses some important benefits of poor inappropriability to which we now turn: correct pricing of IP dissemination and the avoidance of potential duplication of research efforts. With complete appropriability, and assuming an innovation is worthwhile making, technical efficiency for each firm in an industry will involve each firm having access to a cost-reducing innovation. This either means licensing by the innovator, which will occur at a non-zero price, or each firm making the innovation for itself in which case the fixed cost of research is incurred needlessly by many firms. A better solution would be for only one firm to do the research and then share the results; hence the case for government involvement. But firms have some incentives to do this themselves by forming joint ventures (JVs henceforth) to perform R&D (see Grossman and Shapiro, 1986; and Ordover and Willig, 1985). In an industry with many firms there are obvious free-rider problems limiting the formation of JVs and it is unlikely that the market alone will solve the problem of redundant replication unless it is highly concentrated. One other possible solution, in the absence of spillovers, is the licensing of patents by the patentholder and a number of recent papers in the economics literature have considered this (see Kamien and Tauman, 1984; and Katz and Shapiro, 1985). Briefly, the benefits of a JV in avoiding unnecessary duplication of research effort must be set against its tendenc- ies to restrict both innovations and their dissemination. Allowing for spillovers provides another argument in favor of JVs - individual firms do too little R&D from this perspective, whereas a JV internalizes the spillover externality somewhat.

A further complication lies in the role of imperfect competition. This has consequences at the level of R&D itself - if the research industry is imperfectly competitive this may either reduce incentives to undertake R&D (through the absence of exogenous competitive downward pressure on price) or increase them (as the benefits of cost-reduction relative to the fixed cost of innovation rise with market share). It also has consequences for the dissemination of knowledge once gen- erated, as noted above.3

Increasing appropriability alone may be very much a second-best solution. Even though it might induce greater total production of ‘knowledge’, this will be


overpriced as correctly-priced (zero) transfers are reduced. A better policy would increase R&D without affecting appropriability, e.g. an R&D subsidy or a reward for success. However, these are fraught with practical difficulties involving the evaluation of innovations and may be why the patent system is so widespread - it places minimal informational requirements on a regulator and has fewer moral hazard problems than these alternatives.

In summary, the simple analysis of IP as being like any other good is misleading, and consequently so too may be the conclusion that optimal policy involves either full appropriability, or a subsidy to fully correct the underincentive to perform R&D given by incomplete appropriability. Factors to consider are the relative magnitudes of spillover and crowding externalities in the conduct of R&D itself, the size of feasible joint ventures in research, and the structure of the market for dissemination of knowledge as the outcome of R&D. A policy of increasing appropriability alone will be likely to raise social welfare if appropriability is very low, so the disincentive to do R&D is extreme. If R&D firms are large then the common-pool externality is likely to be of less significance, which suggests that correcting the spillovers disincentive by tightening appropriability may be more relevant (subject to the caveat that when the spillover is purely internal to the industry, this too is increasingly internalized by larger firms). However, a concentrated industry is more able to overcome free-rider problems in forming JVs for research and so can internalize the non-appropriability externality without legislat- ive assistance. While a JV has other problems regarding incentives to innovate and disseminate innovations, these cannot be reached by altering appropriability. An R&D industry characterized by a few firms forming JVs, then, seems to provide little case for increasing the appropriability of R&D outputs alone.

3. Open Economy Complications

There are a number of ways in which an international dimension changes matters. First, it may now be foreign firms that benefit from domestic R&D efforts, but the profitability of such firms is not a consideration in domestic social welfare. Second, in considering sales of our goods to foreign countries, we are not con- cerned with foreign consumers’ welfare. Third, domestic policies invite responses by foreign governments and the effects of these must be considered in deciding domestic policy. This also raises the issue of the best forum in which to settle IP disputes, unilateral or multilateral, as nationally and globally optimal policies may conflict.

The previous section made it clear that there are many conflicting issues depending on how IP is modeled. Henceforth I shall concentrate on one particular model.4 I suppose there is a single firm conducting its own R&D facing some concave probability of ‘success’. If successful the firm gains a valuable innovation but there is some spillover of this innovation by patent or copyright violation to other firms, both domestic and foreign. As the nature of IP is such that once it


has been obtained by an infringer the cost of production thereafter is just the cost of the vehicle containing the IP, it is misleading, in a sense, to talk of varying degrees of appropriability. The degree of spillover to which we refer is the size of the final market that is served by infringing non-innovators and this can be restricted (i.e. appropriability be tightened) by increasing the punishment for infringers, effectively raising their costs and increasing the market power of the patentholder. I model patent violators as a fringe in the final good market which can be of varying degrees of competitiveness while the innovator still earns pure profits (in an ex post sense). A policy of increasing punishment for pirates has consequences for domestic consumers and consumers’ losses from an innovator’s increased monopoly power must be weighed against the expected profit-shifting gains. The innovation is embodied in some final good (thus I am not considering process patents here) which is sold to consumers and the spillover is that other firms also share in that market to some extent. The domestic government can control spillovers through varying appropriability regarding sales in the domestic market, and can apply different standards of IP rights enforcement to domestic and foreign infringers. I assume that the patentholder’s product and those of rivals are perfect substitutes, thus finessing any issues of quality differences. I also suppose, for concreteness, that the laissez faire situation is one in which there is socially too little R&D - the spillover externality dominates any common-pool effect. With infringement, the sale of the final good will tend to be more competitive than without.

3.A. A FORMAL MODEL

The single, domestic potential innovator spends an amount x on R&D. The probability of the project succeeding is I[X] < 1, r[O] = 0, r’ > 0, r” < 0. The value of success is summarized as V, so ex ante expected profits are:

?T=r[x]V-x+&x-F

where F is a fixed cost of R&D and s, a subsidy of R&D inputs. Success means the development of a technology that permits production of a final good at some constant marginal cost of c. But other non-researching firms will steal the technology, at no cost, and produce the final good too. Infringing firms face a binding capacity constraint of Q for domestic firms in total (at total cost Fd) and /3 for foreign firms (at total cost Ff).

This set-up could be thought of as describing, for example, the production of software. A firm hires programmers at a total salary of x and the probability of successfully developing a marketable program is increasing in the number of programmers on the job. If a successful program is developed then it is marketed in quantity q by the innovator. But both domestic and foreign infringers can steal the program and sell pirated copies. One can think of there being some threshold level of pirate sales that the innovator will tolerate before taking action against


infringers, and this corresponds to (Y and /3 for domestic and foreign pirates, respectively. These need not be the same: to the extent that a complaint procedure against a foreign infringer is easier than one against a domestic one, for example (and one might interpret 4337 as making this the case), the innovator will tolerate less foreign infringement than it will domestic. Of course, by assuming the infringers do not exceed these threshold levels, I am supposing there will not actually be any complaints by the innovator in equilibrium.

Total sales of the final good are then q + (Y + /3 and so

(2)

where s, is a subsidy to the innovator on sales of the final good. First-order conditions for the innovator’s choices of R&D expenditure and sales of the final good are then:

Vr’ - (1 - s,) = 0, or (p + sq - c)qr’ - (1 - s,) = 0 (1’)

p+qp’+s,-c=o (2’)

Expected social welfare is then the sum of expected consumer surplus (CS) should the project succeed, the cost to government revenue (gr) of subsidizing both R&D and, if the project succeeds, sales of the final good by the innovator, the innovator’s expected profits and the profits of domestic pirates (7~~) if the project succeeds:

w = rcs + (rq(p + sq - c) - x(1 - s,) - F) - (s,x + rsqq) + r(ap - Fd) m gr -d

That is, after cancelling terms,

W=r(CS+(p-c)q+(ap-Fd))-x--F

So domestic welfare consists of the expected benefits from innovation - consumer surplus (CS) plus the pure profits accruing to the innovator ((p - c)q) and to domestic imitators (ap - Fd), all weighted by the probability of success (r) - minus the costs of R&D, both fixed (F) and variable (x).

To find the optimal subsidy levels, denoted with asterisks, given the infringement levels (Y and /3, setting (dW/&,) = 0 and (dW/&,) = 0 gives:

s* = r’(CS + ap - F,) - sqqr’ x

s$ = (r’)-*r”rp’Q(p - c - /3p’) + q-‘(CS + cup - Fd) - (qr’)-‘3,

where Q = - (2~’ + qp”-l> 0 by second-order conditions. Note that each subsidy is declining in the other. This is a consequence of the fact that a subsidy to output, for example, increases the incentives to innovate directly, thus lessening the need to subsidize R&D expenditures. We shall see below that this overlap in the effect of subsidies has implications for the second-best levels of subsidy choices when both subsidy tools are not available.


a+q a+q+B Fig. 1.

Suppose, first, that both subsidies are chosen optimally; denote the jointly optimal levels of the subsidies with double asterisks. Then:

sq ** = -p’(q + p>

sx ** = r’{CS + ctp - Fd + p’q(q + /3)}

Note that, while sg** is always positive, s.z* may be of any sign: a tax or a subsidy. To interpret these expressions, note that from (1’) when the R&D subsidy is

chosen optimally, regardless of sq:

r’[(p - c)q + CS + LX~I - Fd]=l.

That is, R&D expenditure is chosen so that the marginal cost of another dollar put into R&D equals the marginal benefit from another dollar: the increased probability of success (r’) times the social gain from success (innovator profits ((p - c)q) plus consumer surplus (CS) plus domestic infringer profits (op - Fd)).

Also, when st* is levied (2’) implies that p = c + pp’ s c. So if p = 0 we get marginal cost pricing of the final good with optimal subsidies, but if there is any foreign infringement then price will be less than marginal cost. However, we still have marginal cost pricing for total domestic output, as illustrated in Figure 1.

If s, is not optimal then one can show that choosing sq optimally yields

p = c + /3p’ - (q{r”rp’Q + (r’)2})-1[pp’q(r’)2+r’(r’(CS + cup - Fd) - l)]

That is, sq picks up a second-best effect on V in order to correct, partially, incentives for R&D. To illustrate this, suppose there is no infringement at all: (Y = /3 = 0. Then s$ yields:


p = c - r’(q{r”rp’Q + (r’)2})-1(r’CS - 1).

So, if the expected consumer gain from an increased probability of success exceeds the cost of another dollar of R&D (i.e. if r’CS > l), then sq will be chosen so that p < c. That is, the subsidy on final good sales would be increased which increases the value of success to the innovator and so induces greater R&D expenditures. In this way the subsidy on final good sales can partially do the job of a subsidy to R&D.

Now consider the case where subsidies are either not available or are infeasible (perhaps because of moral hazard problems). That is, sq = s, = 0. The innovator’s problem is:

Maxr=r[x]V-x-F where V=maxpq-cq {xl I41

First-order conditions for these choices are:

(p - c)qr’ = I

(p - c) = -qpI

Then

(1”)

(2”)

dW - = (qr”)-‘(r’)‘(CS + CUP - Fd - rp’((q + P)Q(P' + qp”) + P) dfi P L

(a) (b) and

dW dW --+rp.

z- dp

The expression for (dW/dp) contains two terms and that for (dW/da) is the same but with an additional effect. Term (a) in each is a welfare loss due to any increase in pirate sales which reduces the innovator’s expected profits. This would lead to decreased R&D, and therefore decreased probability of success and foregone consumer surplus and domestic fringe profits. Term (b) is the beneficial direct effect of increased infringement on the price of the final good: this increases welfare. Finally, an increase in domestic infringement has the added effect of yielding additional revenue to domestic infringers; hence the added rp term in (dWlda).

It should be apparent from this that the optimal degree of infringement by domestic infringers can be no less than that for foreign pirates. Suppose (Y = p and these are such that (dW/d@ = 0, i.e. foreign infringement is at the optimal level. Then (dW/da) > 0.5 But note that if the domestic fringe always breaks even

(’ i.e. there are no rents in the pirating industry) then welfare is W =

r&S + (P - cM - x - F. Deriving (dW/da) and (dW/d@ here one can show that changes in (Y and p then affect welfare in the same way and there is no reason to discriminate between pirates of different origins. This is an important point for


later reference: discrimination in favor of domestic infringers is only warranted to the extent that pirating earns pure profits.

Finally, what are the optimal levels of infringement when we can also levy subsidies? If both s** and s** 4 x are levied then one can show that (dW/da) > 0 for all a and (dW/d@ > 0 for all /3. (In fact, one can show that /3 = 0 is a local minimum.) These odd-looking results are consequences of the fact that /3 and (Y are given and infringement occurs at zero marginal cost. A small increase in, say, /3 will drive down the price of the final good and make consumers better off. But the fall in p has no effect on 4 or (Y when optimal subsidies are levied: sz* will rise to compensate the innovator. Thus there is a transfer from the government to producers and from producers to consumers, but no effect on profits and thus none on R&D expenditures. This is just an example of the effect noted earlier that spillovers are desirable because of their benefits to consumers - here the disincentive effects for R&D expenditures are offset by an optimal subsidy.

So, in this simple model, I have shown how different policies adjust depending on what tools are available to the regulator. Regarding discrimination across infringers, there is only a case for this if pure rents accrue to infringers. Finally, if subsidies calz be used to affect incentives to innovate, infringement should be encouraged for its desirable effects on the pricing of output. I now discuss the implications of relaxing some of this model’s simplifications; particularly in allowing foreign sales, potential foreign innovators and more domestic innovators (so reintroducing common-pool effects).

Two objections to this analysis are worth addressing. First, it generates rather complicated formulae defining optimal subsidies in terms of the informational demands they would place upon a regulator. For instance, they require a regulator to know how the probability of success varies with R&D expenditures. One might argue that this militates against the use of subsidies but it should be clear that these problems arise equally in determining the correct degree of appropriability, if that is one’s policy tool. There is a common presumption amongst many com- mentators in this area that full appropriability is always desirable; we have argued that this is not necessarily the case and so determining the correct degree of appropriability is not immune to the problems of complexity that haunt the determination of optimal subsidies.

A second possible objection relates to the informational problems of subsidies and incentives. It is often suggested that subsidies are infeasible6 corrective tools in this area because of the difficulty of identifying ‘success’ (even ex post) in a reward system, and the inefficient distortions inherent in subsidizing inputs rather than outputs in a regular subsidy scheme. However, direct governmental involvement in R&D itself is one possible solution (contingent on developing successful incentive schemes for government laboratories) and it is also possible to think of other schemes which can minimize these incentive problems. For instance, a reward scheme of a very broad nature (such as the Nobel prize) can make a reward contingent on successful market performance of a product. In this way, the


market still ‘picks the winners’ but the government provides financial incentives in place of monopoly rents.

3.B. DOMESTIC MARKET INTERACTIONS

The presence of spillovers to and from foreign firms might affect the analysis in a number of ways. Since domestic welfare does not consider the profits of foreign firms and since the existence of ex post profits to the successful innovator is necessary to induce inventive activity, there is a clear reason to prefer innovation by domestic rather than foreign firms. However, this does not create a case for encouraging domestic innovation as ex ante rents are zero: encouraging domestic R&D earns zero pure return at the competitive margin. Note also that any case for encouraging domestic innovation through increased appropriability implies increasing protection against both foreign and domestic infringers and offering less patent protection to foreign innovators than to domestic ones. Any case for discrimination across infringers is a separate issue.

Once an innovation has been made, is there any reason to wish to affect the foreign/domestic split of the infringing market? In each case infringement reduces the price of the final good and raises consumer surplus but, as shown above, there is an incentive to favor domestic infringers if there is any pure profit to infringement. But if foreign infringing firms have either lower costs of production (as in Schwartz, 1990) or better infringement technologies than domestic infringers (being better at reverse engineering, for instance) then there may be an argument for favoring foreign infringers. The excess resource costs of delivering price reduc- tions to consumers through patent infringements by domestic firms rather than foreign ones may outweigh whatever producer surplus gains are involved, if any. In this case, if infringers are restricted (to induce innovation) then it is inefficient domestic copiers who should be penalized more than foreign copiers.

Another point of distinction between domestic and foreign firms may lie in their inventive activity itself. Dixit analyses the case of different success functions for domestic and foreign firms in his model, considering welfare for only one group, and looking at the role of strategic policy by that group’s government. In a Nash equilibrium between the two groups, where the foreign country is purely passive and pursues a laissez-faire policy regarding R&D, if the domestic government would like foreign firms to reduce their R&D it should, “precommit to a level of R&D effort. . . higher. . . than the one it would choose without precommitment” (Dixit, 1988a, p. 167). Other assumptions about the foreign government’s behavior, the types of costs in R&D and the relative sizes of the countries can yield global underinvestment. So strategic considerations are ambiguous, very sensitive to market behavior and therefore informationally demanding. But in Dixit’s model, “in every case the corrective incentives and the strategic ones tend to run counter to each other” (Dixit, 1988a, p. 169). If R&D has low fixed costs but high recurrent costs, for example, then common-pool externalities are less important,


spillovers are relatively more significant and domestic corrective policy would tend to be an’R&D subsidy. Dixit shows that the foreign reaction function is then likely to be upward-sloping and we can induce a reduction in their R&D by reducing our own: this suggests taxing domestic R&D. The net case for policy is thus weakened when both factors are considered.

But Dixit’s analysis emphasizes common-pool effects (a negative externality) rather than spillovers. If the latter is more important, then we would like foreign R&D to increase and strategic and corrective policies would then work in the same direction, and this strengthens the case for policy. But exact optimal policy still depends on the nature of costs, firms’ relative sizes and so on, and is no less informationally demanding. If there are beneficial spillovers beyond the industry itself, these will be relatively more significant in a country with a few, large research firms: the crowding problem is lessened and these spillovers take on greater significance. Such a country would then tend to have too little R&D.

There may be repercussions of policies levied at the domestic level other than factors relating only to the domestic market and to foreign infringement on domestic firms’ patents. As noted, a domestic government would like to distinguish between foreign and domestic holders of domestic patents in order to provide differential incentives for innovation (especially where reaction functions are downward-sloping) but whether or not distinguishing between infringers on the basis of national origin raises welfare depends on the nature of relative infringement technologies and on the profitability of infringers. Note the conflict in the latter case between consumers’ interests and profit-shifting motives: only if the infringing market is non-competitive is there any incentive for favoring domestic copiers, but if the market is non-competitive then consumers’ surplus is more important, at the margin, and we may not wish to discourage foreign copiers particularly if they are technologically advantaged.

3.C. FOREIGN MARKET INTERACTIONS

Consider now the repercussions of domestic policy on foreign markets. We have supposed that the domestic government cannot reach foreign markets directly in enforcing appropriability, but its domestic policies generally will have repercussions both through firms’ behavior and through retaliation abroad. If the domestic market is a substantial part of the world market for the final good, then giving domestic firms an advantage at home also aids them abroad. By increasing the domestic reward to successful innovators a government can induce domestic firms to expend more on R&D thereby increasing their probability of making a successful innovation. To the extent that innovations can be patented in foreign markets this means that rents from those markets are also more likely to accrue to domestic firms. Note that because the wellbeing of foreign consumers does not enter into domestic welfare, a government would prefer that appropriability in foreign markets is absolute and does not discriminate between domestic and


foreign firms, at least insofar as its own firms are likely potential innovators. But some domestic firms are likely to benefit as patent infringers abroad regardless of the origin of the successful innovator and so again the degree of competitiveness of the infringing market becomes relevant. If it is competitive then there are no rent-shifting reasons to prefer foreign laxity on patent enforcement. If not, then to the extent that domestic firms will gain rents by infringing on patents abroad, we would prefer foreign laxity. Of course, this is a situation where the foreign government is trading off its own conflicting rent-shifting and consumer surplus incentives for varying the degree of appropriability.

This raises the issue of foreign governments’ actions and reactions to ours, which arises in a number of ways. So far it has been implicitly assumed that production of the final good takes place in the country in which the good is sold but in fact there will generally be trade in the final good and the issues regarding pricing of the final good can be reinterpreted as terms-of-trade (TOT henceforth) considerations. Suppose the successful innovator produces the good at home and exports to the foreign market. Ex post, the importing country (foreign) may wish to restrict imports in order to counter the exporter’s monopoly power and so reduce the price it pays for imports (depending on the configuration of demand and costs - see Hillman and Templeman (1985) for references). One way to do this is for the foreign government to permit sales in its own country in contravention of any patent it has granted. This is the point made earlier that welfare of consumers is important, particularly when the monopolist is foreign.

Ex ante, it is not known if the successful innovator will be domestic or foreign and such a policy would tend to discourage domestic R&D (unless the country could discriminate between internal patentholders on the basis of their origin). In the special case where there is only one country engaging in R&D (the home country, say), the other country proposing to free-ride on any innovations by home firms, suppose initially there is full appropriability both at home and abroad, no re-exporting and positive demand for the final good in both countries. In this case the home country will export the final good, the innovator holding patents in both countries.

All TOT gains available to the exporting country will now be reaped by the monopolist firm and there are no TOT reasons to restrict exports further. Let us suppose that the importing country would wish to restrict imports to exercise its monopsony power: one way to do this is to permit infringement on the patent. If this occurs, and is done by both home and foreign firms, then the home country - the country of origin of the innovator - does have a TOT incentive to reduce exports of the final good (at least for small levels of infringement). The reason for this is that total exports, by the patentholder and the domestic share of the copying fringe, will exceed the nationally optimal level as the pecuniary externality on the TOT is no longer completely internalized. With a domestic fringe each firm ignores the pecuniary externality its sales have on the profits of others. (If infringement is only by foreign firms, of course, then this argument does not


apply.) One way to reduce exports is for the domestic country to restrict infringement by domestic firms on patents held by domestic firms abroad. Again, the nature of the infringing firms is important here - if decreased sales of domestic infringers are just replaced by increased sales by foreign infringers then there can be no gain from such a policy. But if domestic infringers have a technological advantage over their foreign counterparts then there may be a domestic gain from restricting their operations abroad.

In the model described earlier, the domestic market is the only market, so the country is an importer of the pirated good. As a result, there are no TOT reasons for restricting domestic infringement of the sort discussed above. However, there is a case for imposing a tariff on imported infringements (insofar as they are observable) because, in this model of a fixed volume of infringing sales, such a tariff has no effect other than shifting foreign rents to the domestic government. This is just an extreme case of the optimal tariff argument, and the principle still applies in a more general model where the extent of foreign sales varies with price - a tariff would then reduce foreign infringement and have the same consequences as a quantitative reduction in those sales except that it would also yield tariff revenue.

This raises the general question of how best to restrict infringement in the event that there is a case for such restriction. We have argued that increasing the ease of complaints for an innovator increases the expected costs of infringement and so reduces such activity. In that case, policy-created rents are dissipated in the form of the costs of the complaints procedure. Alternatively, as in this paper’s model, reducing the costs of complaining lowers the threshold level of infringement the innovator will tolerate and thus reduces pirate sales. In this case, the rents attributable to the policy accrue in part to the innovator and in part to infringers (who now receive a higher price for what infringement remains). In either set-up a tariff would be a preferred method of restriction as it captures all policy rents domestically.

One further case is of some interest in this context. Suppose there are domestic spillovers from R&D itself, not just the innovation. Each country would then wish to offset the underincentive to perform R&D caused by these externalities, without concerns for spillovers to foreigners. International interactions now arise as each attempts to foster the same industry. This is rather different to standard tariff wars, wherein each country attempts to encourage domestic production of (different) importables (cf. Mayer, 1981) and has a similar flavor to recent arguments for industrial policy in the presence of labor rents. In a series of recent papers (see references) Katz and Summers have looked at the latter issue and have, in passing, referred to the significance of retaliation by foreign countries. They note that there is generally an incentive for a country to subsidize industries in which these rents accrue to labor, and suggest that even with retaliation, the outcome of a subsidy war is likely to be welfare improving for both countries - in contrast to the standard tariff war in which there is no such presumption. The reasons for this

INTELLECIWAL PROPERTY RIGHTS 261

difference are not fully articulated, but presumably lie in the fact that a no- intervention equilibrium is not globally first-best in their case whereas it is in the optimum-tariff war. However, while this observation is correct, it does not create any presumption that the subsidy war outcome is any better than the laissez-faire outcome. Small subsidies in both countries may well raise welfare, but the outcome of a subsidy war may well involve both countries going ‘too far’ the other way.

This applies equally in the present case. Without any intervention, our maintained assumption is that R&D is too low in both countries. Each would then wish to increase it, and there is no reason to suppose that the final Nash equilibrium in subsidies is any better than the laissez-faire outcome for either country even though the globally optimal policy may involve positive subsidies for both.

3.D. NATIONALLY- VS. GLOBALLY-OPTICAL POLICIES

To compare nationally and globally optimal policies, suppose the countries involved were co-operative and chose policies to maximize world welfare, as if all parties entered the same social welfare function equally. The differences between such policies and nationally optimal policies then stem from: (1) the absence of foreign parties in the social welfare function in the latter case, which has both direct and indirect effects as strategic governments attempt to modify foreign behavior in ways that benefit domestic parties; and (2) the co-ordination of policies across countries. The determination of globally optimal policies has essentially the same considerations discussed in Section II but at an international level. So, if there are no binding resource constraints limiting the location of R&D or final- good production, the problem facing a global planner is exactly that in Section II but where the ‘country’ is actually the world economy.

Each country, however, has an incentive to foster research by its own firms regardless of relative ‘productivities’. This feature is not present in a global optimum as the latter would promote only those firms most likely to succeed. So this effect encourages global overinvestment in R&D in the non-cooperative outcome. We noted above that countries individually ignore consequences of their policies on foreign firms. The significance of this, given the limited reach of countries’ appropriability policies, is that countries would like to encourage domestic infringement on patents held by foreign firms. If countries can distinguish between foreign and domestic holders of domestic patents this introduces a disincentive for R&D: a firm will reap smaller profits abroad due to infringement. A maintained assumption in this Section has been that in any one country there is too little R&D in the laissez-faire case from the country’s viewpoint. This may be less likely to hold on a global scale if the trade-off between common-pool and spillover effects alters, but the direction in which it is altered is indeterminate.

All in all, then, it is not clear in which direction a non-cooperative outcome will differ from a global optimum regarding the amount of R&D conducted. Even were that issue resolved, there is still the problem of what degree of appropriability


would be globally optimal. Suppose that R&D is too low in a non-cooperative outcome. If subsidies are a possibility then a global optimum might involve a subsidy to R&D to increase it without reducing spillovers, but in their absence a suitable degree of appropriability will trade off the disincentive to perform R&D against the reduction in spillovers. This might involve either tightening or relaxing appropriability from the non-cooperative outcomes.

4. Section 337 of the Tariff Act of 1930

An interesting case study to analyze in light of the discussion above is provided by current U.S. treatment of infringement on domestic IP rights by domestic and foreign pirates. Section 337 of the Tariff Act of 1930 permits the International Trade Commission (ITC) to prohibit the import of goods into the U.S. where there are “[ulnfair methods of competition and unfair acts in [their] importation”. The main application of this section has been to IP issues,’ to reach both goods that directly infringe a domestic firm’s U.S. IP rights and those goods manufactured by means that infringe on U.S. process patents. The 1974 Trade Act made several changes to $337 which had the effect of encouraging its use by domestic litigants seeking to exclude imports: it changed the role of the ITC from a purely investiga- tive one, recommending steps to the President, to an enforcement one; and it also required the ITC to reach a decision on a case within twelve months (or eighteen months in more complicated cases) of the publication of the nature of investigation. Section 337 is an attractive medium for complaining of foreign infringers for a number of reasons. First is the relative speed of the process in contrast to litigation through a district court. Also, a firm can initiate both proceedings at once as $337 litigation provides relief “in addition to any other provision of law”. A second advantage of §337 litigation is that relief can be in the form of orders against goods rather than parties, so no jurisdiction need be established over foreign producers and nor does the litigant need to name all parties against whom a remedy is sought - an ITC order applies to all infringing products.

A full description of the status of 0337 prior to 1988 is available in Wilson and Hovanec (1986). In 1988 $337 was considerably strengthened by the Omnibus Trade and Competitiveness Act (OTCA).’ Barton (1989) provides further details of these amendments, but the general flavor is clear - infringement by foreign firms on U.S. IP rights within the U.S. are more easily complained of and punished than is infringement by domestic firms. Barton (1989) presents a compelling case that the considerable discrimination against foreign infringers in U.S. law cannot be justified as being necessary to make IP rights effective and thus violates the provisions of GATT. The distinction between $337 complaints and court proceedings can thus be viewed as one of differing degrees of appropriability with the former being the more tight. The costs to a foreign firm of infringing on a U.S. patent will, cereris paribus, be higher than those to a domestic firm - the remedies


for the firm holding the patent are more accessible and more generous in dealing with foreign infringers, so a complaint by the patentholder is more likely and the expected costs of infringing are thus increased.

The location of the patentholding industry is important in this, however. A holder of U.S. IP rights cannot use $337 to differentiate between domestic and foreign pirates (as each faces the weaker appropriability standard of regular court litigation) unless the firm has, “significant investment in plant and equipment; significant employment of labor or capital; or substantial investment in [the] exploitation [of the protected good] including engineering, R&D, or licensing” (OTCA 1988, $1342(a)(l)). So $337 may give an incentive for foreign firms to locate production within U.S. borders.

To the extent that production of a final good is located within the country of origin of the firm that innovates, the stylized effect of $337 is to increase a domestic U.S. patentholder’s appropriability against foreign infringers, relative to that against domestic infringers, and thus to give greater protection to domestic rather than foreign holders of U.S. patents. In light of the earlier analysis this is as one would anticipate if there are ex ante profits to innovators - greater innovation incentives by domestic firms than by foreign ones. If the U.S. market is substantial and a foreign innovator is induced to locate production within the U.S. in order to increase appropriability, there may be another gain to the U.S. if as the innovator’s profits are taxed here. However, this is all true only if the domestic fringe is imperfectly competitive; otherwise a consequence of $337 might simply be to replace foreign pirates with domestic ones, having no consequences for the overall incentive to innovate.

We have suggested there may be grounds for favoring domestic infringers if they are more efficient than foreign pirates and to shift rents to domestic firms. A measure such as $337 will be more beneficial where the pirate fringe is not competitive, in which case there are positive effects both on domestic patent violators’ profits and on incentives to innovate which weigh against consumer losses in the final good market. But one of the appealing features of $337, to a complainant, is that remedies issued by the ITC apply to all infringing products and not just those of the respondent in the instant case. This differs from regular court litigation and suggests that $337 action might be more prevalent in industries where the infringing subset of firms is large and comprised of many firms. If this is the case then it is also likely to be fairly competitive and thus there will be little room for such rent-shifting policies by the U.S. government.

A general tenor of discussion prior to the strengthening of $337 in 1988 was that U.S. firms were technological leaders and were generally likely to be victims of IP rights infringement rather than the perpetrators of it.9 If this perception is accurate, the model of Section III seems an appropriate case for analysis - only a domestic firm pursues R&D but others, both foreign and domestic, infringe on the final good market. Recall that the model assumed that infringers’ sales are


not variable due to the existence of some threshold level of sales beyond which they will trigger a complaint by the innovator. The tightening of $337 can thus be thought of as reducing the costs of litigating against foreign infringers, thereby reducing the threshold level of foreign infringement, and the model can be applied directly. Its main results suggest, first, that subsidy policies alone may correct the faulty incentives both to perform R&D and to increase sales of the final good (ignoring moral hazard aspects of such policies) and, second, when there are no rents in the infringing sector, there is no reason to discriminate between domestic and foreign infringers.

In this sort of asymmetric model, the earlier arguments regarding foreign reactions do not apply: there is only one potential innovator, and we do not get symmetric reasons for reactive policies by foreign governments. Facing restrictions on the degree to which their firms can infringe on U.S. patents, there are no reactive policies that are in their interests (other than adjusting any optimal export taxes levied on their firms: if they tax their firms to restrict sales to the U.S. and thus to increase the price they receive, then increased U.S. restrictions will generally necessitate a change in that tax rate, to lessen the fall in domestic welfare). There may be strategic reasons for policy reactions in other areas - as threats to prevent U.S. restrictions - but, insofar as the U.S. policy has been committed to, there is little rationale for such retaliation. This all suggests that the U.S. may have little to fear regarding foreign policy repercussions of its 9337 tightening. There is some evidence, however, that the U.S. is being increasingly challenged as a leading innovator by other countries.” Thus the earlier analysis with all countries facing the same problems and policy incentives may be becoming increasingly appropriate and so these repercussions cannot be ignored.

In sum, I have argued that excluding products which violate U.S. IP rights is not obviously in the U.S.’ best interests and that there are a number of reasons such IP rights infringement is socially beneficial. Permitting infringement will generally be only a second-best policy and, in the context in which $337 operates, is unlikely to be even that. It is second-best to a set of domestic subsidies/taxes which can correct faulty incentives for both the volume of R&D and for marginal cost pricing of the final good more directly, and it is second-best to tariffs as a means of capturing rents accruing to foreigners. I have also suggested that while there may be a case for favoring domestic innovators over foreign innovators, for rent-shifting reasons, this really provides an argument for tightening appropriability against all infringers. I1

One final point: the concentration of $337 on infringement issues suggests that spillover externalities are perceived as being important which in turn suggests that optimal corrective policy is to encourage R&D. In that case, strategic policy tends to work in the same direction and we do want to encourage R&D overall. It should be clear, however, that tightening appropriability is not the best way to do it - spillovers themselves are the very reason we wish to increase R&D, so reducing such spillovers, while it may increase R&D, defeats the very purpose of the policy!

INTELLECTUAL PROPERTY RIGHTS

5. Summary

265

This paper has considered the issues of IP rights infringement and enforcement in the context of an open economy. I have argued not only that the problems that plague optimal policy considerations in the closed economy are compounded by the presence of foreign innovators and/or infringers but that domestic policy towards IP protection also is complicated by the behavior of foreign governments in the same sphere. I set up a simple model to examine the first of these sets of issues, demonstrating that differential treatment of foreign infringers will, in general, be unwarranted except for profit shifting reasons and I argued later that such profit-shifting is more efficiently done through tariffs than through import exclusion. The model was also employed to demonstrate the effects of alternative subsidy schemes - on inputs and outputs - and illustrate their interactions with policies controlling infringement directly. Finally, the paper takes a brief look at current U.S. policy in precisely this area, drawing some fairly negative conclusions regarding such policy.

In conclusion, it seems unlikely that domestically and globally optimal policies coincide and, when the possibility of foreign reactions to domestic policy is allowed for, prisoners’ dilemma types of outcome may result as all countries offer rent- shifting subsidies. While the U.S. may once have been sufficiently dominant in world R&D activity that other countries had no strategic incentives for R&D policy, this is probably no longer the case. Thus any changes in U.S. policy are likely to induce policy reactions abroad which may operate to the U.S.’ detriment. Hence it would seem to be in the interests of all parties to deal with IP rights in a multilateral, cooperative setting such as GATT rather than through unilateral, discriminatory policies.

Notes l I am grateful to Marius Schwartz for helpful comments on earlier drafts of this paper. Any remaining errors are, of course, my own. i It should be noted that the only sorts of spillovers considered in this paper are those relating to the final production of IP. Reinganum (1982) inter alia, also considers spillovers of progress gained during

a patent race, rather than the final product itself. Further, we ignore all dynamic considerations in R&D and consequent complications regarding technical leadership, pre-emptive R&D and strategic incentives to speed up or delay an R&D program. While interesting, these are beyond the scope of this paper. * This has long been recognized, however. See Hirshleifer and Riley (1979). s One interesting permutation is where an independent researcher holds a patent and is selling to a perfectly competitive downstream industry. In this case the demand for the output of R&D may not be a smooth function of the price. If all downstream firms are identical with a fixed cost and increasing marginal costs of production then their demands for a fixed-cost reducing IP innovation will be unit demands: one might buy a piece of software at some price, but one does not buy more of the same information as the price falls. Then individual demands of each firm for the innovation sum to a rectangular market demand and the fact that the patentholder is a monopolist is irrelevant from the point of view of social welfare - all surplus can be extracted from downstream firms and there is no deadweight loss associated with this.


4 Full workings of this model are available from the author on request. ’ This tends to support the effect of $337, discussed later. 6 And yet subsidies and other forms of direct governmental involvement in the R&D process seem very popular. The Economist of Nov. 11, 1989 states that over 50% of total R&D in the U.S. is funded by the public sector and non-profit organizations (and over 30% in Japan and 35% in W.Germany.) Admittedly, a lot of this is military expenditure but, at least in the U.S., this is very widely defined. ’ From 1175 to 4/85 only 4% of cases taken to the ITC under $337 did not involve IP: USCC (1988, p. 39). ’ Prior to 1988 there were a number of requirements to be established by a complainant under $337. First, the respondent must be involved in *unfair’ acts or competition. Second, this must be to do with the importation of articles or in their sale (although the ITC may not investigate matters “based solely on. acts. . . which are within the purview of the several statutes applying to countervailing duties or to antidumping” (Simms, 1982, p. 252, italics added). Third, a domestic industry must exist for the ITC to have jurisdiction, and in order for the fourth requirement to be possible, that injury to the industry must result from the act complained of. Finally, the domestic industry must be efficiently and economically operated - the ITC has never found this not to be the case. In 1988 the Omnibus Trade and Competitiveness Act made a number of changes to this procedure that operated in the complainant’s favor. The injury requirement was weakened substantially and the requirement that a U.S. industry be efficiently and economically operated has also been dropped. The ITC, at the request of the petitioner, must decide within ninety days (one hundred and fi f ty days in more complicated cases) whether or not to grant temporary relief from imports while the complaint is being investigated. Also, where an import has been previously denied entry, being subject to an ITC expulsion order, the new law permits seizure and forfeiture under certain conditions of notice. 9 The conference report of the House of Representatives on the Omnibus Trade and Competitiveness Act of 1988, for example, reports a Congressional ‘finding’ that, “United States persons that rely on protection of intellectual property rights are among the most advanced and competitive in the world” (p. 112). Aside from making one wonder why then the requirement for an efficiently operated domestic industry needed to be dropped, there is considerable evidence that foreign firms have at least been catching their U.S. counterparts in recent years. Also, in 1988 only 11 $337 petitions were filed with the ITC whereas Ordover and Willig (1989, fn. 34) report that over 6000 IP suits were filed in U.S. federal courts. These numbers suggest that domestic infringement is not trivial. lo The Economist (October 28, 1989) reports that only two of the ten companies securing the most patents in the U.S. were American in 1988 (versus seven in 1975). Some 48% of U.S. patents granted in 1988 went to foreign firms, compared to 30% in 1970. r1 If, de facto, all infringers happen to be foreign, one might argue that the differential treatment embodied in $337 versus regular court proceedings is harmless. But an alternative interpretation is that equal treatment would also be harmless on this score but would satisfy U.S. GATT obligations and thus be less contentious.

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Intellectual property rights: An international economics perspective