Intellectual property rights, multinational firms and technology transfers

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Abstract

Intellectual Property Rights (IPR) protect firms from imitation and are considered crucial to promoting innovation and technological diffusion. This paper examines the impact of IPR on import-sourcing decisions of multinational firms. We consider a framework in which firms offshore production of an intermediate good to another country. Firms can decide either to import the intermediate good from vertically integrated producers, or from independent suppliers. In both cases, offshoring part of the production process embodies a risk of imitation. The model predicts that, under reasonable parameter restrictions, stronger IPR disproportionately encourages the imports of intermediate goods through vertical integration. Using the US Related-Party Trade database, we find empirical evidence supportive of the positive link between level of IPR and the share of imports from vertically integrated manufacturers.

Introduction

Anecdotal and empirical evidence stresses the importance of intellectual property protection and technology transfers for international trade, especially in developing countries. Where intellectual property rights (henceforth IPR) are weak, this can discourage firms from offshoring production to foreign countries. Offshoring requires the transfer of some technology abroad, and this exposes multinational firms (henceforth MNF) to the risk of imitation and technology expropriation (see Lee and Mandsfield, 1996). There is a potential risk of imitation when firms use outsourcing contracts (see Yang and Maskus, 2001), as well as when technology transfers happen within the firm’s boundaries, as in vertically integrated MNF. For instance, Maskus et al. (2005), analysing IPR in China, report that both former licensees (independent firms), and former employees (managers of vertically integrated firms) end up running their own factories, producing their version of the goods, and infringing the related trademarks and patents. They also write that “although FDI in subsidiaries may be designed to keep technology proprietary within the firm, such investments also train local employees and managers and transfer knowledge”. Branstetter et al. (2006) point out that multinational firms investing in FDI are particularly exposed to this risk of imitation. They mention anecdotal evidence such as the case of the world’s leading semiconductor manufacturer, the Taiwanese TSMC, who charged its mainland Chinese rival, SMIC, of intellectual property theft. According to public statements by TSMC representatives, SMIC hired more than one hundred TSMC employees, who brought valuable trade secrets with them.

Therefore, weak IPR in the destination country can discourage within-firm trade flows, and the associated technological transfer. Fig. 1 provides an illustration of the relation between IPR and the share of overall foreign input purchases that are imported within firm boundaries in the United States. Each point represents a bilateral relation between the United States and the destination country. The vertical axis measures the average share of intra-firm imports from each destination country; the horizontal axis measures the average IPR level in each destination country.1 The higher the level of IPR protection in the destination country, the higher the share of US intra-firm imports in total US imports.

The main contribution of this paper is to provide theoretical and empirical support to the idea that stronger IPR might encourage more strongly the propensity to engage in vertical integration as compared to outsourcing. We propose a theoretical framework based on Antràs (2003) and Antràs and Helpman (2004), embedding the property rights approach in a global value chain context. We consider multinational firms based in a developed country, the North, which offshore production of an intermediate good in another country, with a different level of IPR, the South. When the MNF engages in vertical integration, it imports the intermediate good from a foreign subsidiary; when it engages in outsourcing, it imports it from an independent contractor. Since vertical integration ensures the control of the physical capital, it shapes the contractual relationship in favor of the MNF. Departing from Antràs (2003) and Antràs and Helpman (2004), we assume that production in the South entails a risk of imitation. More specifically, when IPR are not well protected, the Southern manufacturer can operate the technology on the side, using the technology acquired from the North. Crucially, however, the respective payoffs of the multinational firm and the imitator are affected differently depending on the chosen ownership structure. Although vertical integration guarantees control over the production facilities, the existence of an imitation risk reduces the advantage of ownership. This is in line with Blomström and Sjöholm (1999), Branstetter (2006) and Lee et al. (2016), who show that the transfer of knowledge within the boundaries of the firm is particularly important. The intuition is that knowledge transfers inside firm boundaries allows workers of the multinational firm to sell the technology or to operate it independently, thus favoring imitation.

In our model, technological transfers are larger in more productive firms, which engage in vertical integration. In this context, we show that, for both ownership modes, stronger IPR increases the profitability of the firm. This is consistent with the idea that the risk of imitation exists when dealing with an independent provider, but also with a foreign affiliate. The fact that vertical integration does not shield firms from all hold-up problems is the general message of the property right approach to incomplete contracts (see Antràs and Helpman, 2004 and Antràs, 2015), which also find empirical support (see for instance Corcos and Verdier, 2013). Our paper extends the analysis of incomplete contracts and hold-up to account for intellectual property rights, i.e. control over intangible assets and ideas. In our framework, the existence of knowledge spillovers, makes vertical integration unable to solve the incomplete contract problem, especially when IPR protection is low.

Our model shows that, under reasonable parameter restrictions, higher IPR protection has a stronger effect on vertical integration. This happens because an increase in IPR restores the advantages of vertical integration in the bargaining problem, reinforcing the MNF’s control over both physical capital and intangible assets. This implies that strengthening IPR in the South increases intra-firm imports relatively to imports from independent suppliers. Since in our model vertical integration induces larger knowledge spillovers, the Southern manufacturer can imitate the technology more easily under vertical integration than under outsourcing.

To empirically examine the role of IPR in affecting the global sourcing decisions of firms, we combine the index of patent protection in Park (2008) with data on US intra-firm trade taken from the US Census Bureau’s Related Party Trade Database.2 Our baseline empirical specification considers the impact of an increase in IPR protection on the share of related party intermediate imports, controlling for industry and country characteristics. We find a positive and statistically significant impact of IPR, which supports the theoretical finding that an increase in IPR protection is more valuable for vertically integrated firms. To correct for the potential endogeneity of IPR protection, we use a two-stage instrumental variables approach. As a first instrument, we use difference in countries’ legal origins: the underlying idea is that legal origin is an important determinant of national institutions. This strategy is similar to Hu and Png (2013) and Nunn (2007). Naturally, using legal origins makes it impossible to exploit the panel dimension of the data, because this variable does not change over time. We thus propose an additional time varying instrument: outward migration of students. Migrating student, through different links with the home countries, can also influence the attitude toward institutions, as well as have an impact on technological diffusion. To reduce endogeneity concerns, our instrument takes the average number of migrating students from neighboring countries, excluding the country of interest, and it is lagged fifteen years. The estimated effect of IPR on intra-firm import shares continues to be significant. We also assess the sensitivity and robustness of our results. Firstly, to establish whether the impact of IPR enforcement is enhanced in patent-sensitive industries, we explore the role of differences in industry-level sensitivity to IPR. Then, we show that our results are confirmed using an alternative measure of IPR. All specifications confirm the main finding that an increase in IPR protection boosts the share of US intra-firm imports.

The paper is structured as follows. Section 2 describes the contributions of this paper with respect to the existing literature. Section 3 presents the theoretical framework. Section 4 characterizes the different organizational forms. Section 5 describes the industry’s equilibrium and derives the prediction to be tested. Section 6 describes the empirical strategy. The estimation results, identification strategy and robustness checks are discussed in Sections 7. Section 8 concludes.

Section snippets

Related literature

Our work is related to different strands of the literature. Firstly, it relates to theoretical and empirical studies on vertical integration and outsourcing, which build on Antràs (2003) and Antràs and Helpman (2004). In this literature, vertical integration is a response to contract incompleteness: vertical integration is here associated with ownership, which defines control rights on the physical capital of the firm, thus reducing opportunistic behavior and hold-up problems. We take a

The model

We adopt a monopolistic competition framework in line with Antràs and Helpman (2004). The world consists of two countries, North and South, and one factor of production, labor. Consumers have identical Dixit-Stiglitz preferences represented by:U=x0+1μj=1JXjμ,0<μ<1,where x0 is a homogeneous good, Xj is aggregate consumption in sector j, and μ is a parameter. World aggregate consumption in sector j of different varieties xj(i) is given by:Xj=[xj(i)αdi]1α,0<α<1where i is the endogenous range of

The incomplete contracts problem

Under both vertical integration and outsourcing, contracts are totally incomplete. This implies that parties cannot commit ex-ante to a certain distribution of the surplus. The assumption of incomplete contracts follows the property rights approach, which introduces the hold up problem for vertically integrated structures (Grossman and Hart, 1986). We denote β and 1β, with β[0,1], the bargaining weights of the final good producer and the Southern manufacturer respectively. Both vertical

Equilibrium

Under vertical integration, the final good producer and the manufacturer maximise (7) and (8) respectively, while under outsourcing they maximise (11) and (12). From the first-order conditions of these programs and using (4) we can write the total operating profits as:πk=A1/(1α)θα/(1α)Ψk(βk[λ])wNfk,k={V,O},whereΨk(βk[λ])=1α(βk[λ]η+(1βk[λ])(1η))((1/α)(wn/βk[λ])η(ws/(1βk[λ]))1η)α/(1α),k={V,O}.

It is important to note that Ψk(βk[λ]) is not necessarily increasing in λ. When λ increases, the

Empirical evidence

The goal of this section is to quantify empirically the role of IPR in affecting the global sourcing decisions of firms. We exploit industry-level variations, taking advantage of the US Related-Party Trade database made available by Pol Antràs.9 The dataset provides information

Benchmark specification

We now turn to our estimations. OLS estimates of Eq. (25) are reported in Table 1. In column (1) we provide estimation results for Eq. (25) including only the IPR variable, and controlling for country, time, and industry-time unobserved characteristics. The estimated coefficient for IPR is positive and statistically significant, which supports the idea that an increase in IPR protection is more valuable for vertically integrated firms. This is consistent with our intuition that vertical

Conclusion

Intellectual property rights can have non-trivial effects on the ownership structures of multinational firms. In this paper, we provide a theoretical and empirical evidence of the role of intellectual property rights in affecting the relative attractiveness of vertical integration with respect to outsourcing. Our model embeds the property rights approach in a global value chains context, stressing the role of intangible and knowledge goods. We extend the existing literature on global sourcing

Declaration of Competing Interest

The author, Pamela Bombarda, declares that she has no relevant or material financial interests that relate to the research described in this paper.

The author, Sara Biancini, declares that she has no relevant or material financial interests that relate to the research described in this paper.

Acknowledgments

We are grateful to the editor Daniela Puzzello, two anonymous referees, and an anonymous associate editor for comments that substantially improved this paper. We would also like to thank Carlo Altomonte, Giuseppe Berlingieri, Lionel Fontagné, Alireza Naghavi, Rodrigo Paillacar, Régis Renault, and Ariell Reshef for constructive and helpful suggestions. Remarks from participants at the 2016 ETSG Helsinki, the CESifo Workshop in Applied Microeconomics, the EARIE 2018 Athens, and seminars at

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