Journal of Chinese Economic and Business Studies

Vol. 8, No. 3, August 2010, 253–267

Market structure, FDI, imitation and innovation: a model of

North–South intellectual property rights conflict
Ziyin Zhuanga and Wei Zoub*
a
School of Economics and Management, Wuhan University, Wuhan, China;
b
Institute for Advanced Study (IAS) Wuhan University, Wuhan, 430072 China

(Received 26 May 2009; final version received 30 April 2010)

We develop an extended North–South model to analyse the US–China

IPRs conflict and possible policies. In our model, innovation in the North
(US), imitation in the South (China), and Foreign Direct Investment (FDI)
are all endogenous. We predict that whether tighter IPRs benefit the US
or China depends crucially on market structure. In an oligopoly market
induced by vertical innovation, tighter IPRs hurt both economies; while,
in a monopolistic competition market induced by horizontal innovation,
tighter IPRs benefit both economies as long as the degree of IPRs is
appropriately chosen. We prove the existence of an optimal degree of IPRs
protection in China, which may differentiate it from that in the US.
Keywords: Intellectual Property Rights; market structure; FDI; imitation;
innovation
JEL Classifications: F23; F43; O31; O33; O34

1. Introduction and related literature

There has been a hot debate between the North and South generally, and between
the US and China particularly, about the enforcement of IPRs.1 The US, for
example, has been pushing a comprehensive agreement with China on the latter’s
commitment to enforce its intellectual property laws, and it has been estimated that
China’s failure to protect US intellectual property rights has cost US companies over
$1 billion annually (US Congress 1995). The IPRs agreement is argued to fit into the
overall strategy of ‘comprehensive engagement’ with China (Winston 1995).
Conventionally, IPRs tend to be seen as primarily an economic or legal issue,
embodied in the rights to ‘ownership’ and thus to the exclusive use of inventions.
But there is also an argument that there is a broader ‘human rights’ dimension,
illustrated by the fact that the right of inventors to the ‘moral and material interests’
resulting from their scientific, literary and artistic productions is recognized in the
1948 Universal Declaration of Human Rights (UDHR). Although the US insists
on pushing China to strengthen its IPRs, it remains arguable whether the two

*Corresponding author. Email: zouwei@whu.edu.cn

ISSN 1476–5284 print/ISSN 1476–5292 online

ß 2010 The Chinese Economic Association – UK
DOI: 10.1080/14765284.2010.493640
http://www.informaworld.com
254 Z. Zhuang and W. Zou

countries with sharp differences in GDP per capita and technology capability should
take the same standards of IPRs. Moreover, before reaching any conclusion, closer
research on the effect of IPRs on market structure, technology diffusion, FDI,
imitation and innovation should be done.
The Agreement on Trade-Related Aspects of IPRs (TRIPs) stipulates that all
members adopt a set of universal minimum standards on IPRs protection. The focus
of the debate is now whether the South should harmonize its IPRs standards with
those of the North. Opponents of tighter IPRs argue that it confers monopoly power
on the creators of intellectual property, generating a static loss. In addition, it will
strengthen the monopoly power of large companies that are based in industrial
countries, hamper the ability of local firms to experiment with and assimilate
advanced foreign technologies at low cost, and hence slow down the rate of global
technological diffusion (Chaudhuri, Gordberg, and Jia 2006; Glass and Saggi 2002;
Helpman 1993; Maskus and McDanniel 1999; Maskus 2000; McCalman 2001, 2004,
2005a, 2005b; Ordover 1991; Westphal, Kim, and Dahlman 1985). By contrast,
proponents of tighter IPRs argue that it may actually enhance the industrial
development process in the South since greater security for IPRs in the South will
encourage MNCs to shift production to the South and stimulate innovation, which
can benefit all the regions of the world (Branstetter et al. 2007; Glass and Wu 2007;
Lai 1998; Lai and Qiu 2003). Our research seeks to extend the general North–South
framework and illuminate the particular US–China IPRs debate by modelling the
effects of tighter IPRs on FDI, innovation and imitation in a dynamic general
equilibrium model.
Most early literature focused the effects of IPRs on innovation and diffusion in
a closed economy (Siebeck et al. 1990). Recently, there have been various attempts to
model the long-term effects of IPRs on the product innovation, economic growth
and terms of trade in the international product cycles. Based on Vernon’s (1966)
original vision of product cycle, Chin and Grossman (1988), Diwan and Rodrik
(1991), and Deardorff (1992) examine the effects of IPRs on the North and South
in a static partial equilibrium framework, and provide valuable insights. Helpman
(1993) develops a North–South dynamic general equilibrium model in which all
innovation takes place in the North. In this model, tighter IPRs in the South
significantly retards Southern industrial development, reduces the South’s share
of global manufacturing and the rate at which the production of newly-invented
goods shifts to the South. Relative to a weak IPRs system, tighter IPRs expands the
North’s share of global manufacturing, but decreases the innovation rate in the
long run, because more Northern resources are tied up in production rather than
innovation.
Lai (1998) builds a dynamic general equilibrium model of the international
product cycle, and allows the level of FDI in the South to respond endogenously to
changes in the tightening of Southern IPRs protection. In contrast to Helpman
(1993), he finds that the effects of tighter IPRs in the South depend crucially on the
channel of North–South production transfer. Tighter IPRs in the South increases
the North innovation rate, and raises relative wages in the South if FDI is the
channel of production transfer, while the opposite effects occur if production is
transferred through imitation. He concludes that tighter IPRs can be more broadly
interpreted as any incentive to encourage Northern FDI.
 Journal of Chinese Economic and Business Studies 255

Glass and Saggi (2002) provide a product cycle model in which innovation,
imitation, and FDI are all endogenous, and reach conclusions different from
Lai (1998). They discern imitation that targets the products of Northern firms from
that which targets the products of MNCs, assuming that the costs of imitating a
MNCs’ product are lower than the costs of imitating a Northern firms’ product.
They find that tighter IPRs protection keeps MNCs safer from imitation, but no
more so than Northern firms. Instead, the increased difficulty in imitation generates
resource wasting, and discourages imitation, which in turn results in a reduction in
FDI, and further, in a reduction in North innovation.
Glass and Wu (2007) try to explore why theories vary about the effects of IPRs
protection on FDI and innovation. In their models, Northern firms innovate to
improve the quality of existing products and may later shift production to the South
through FDI. Southern firms then imitate the products of MNCs. They conclude
that the effects of IPRs protection depend on the nature of innovation. Tighter IPRs
encourage FDI and innovation when innovations are new varieties, but it has the
opposite effect when innovations are quality improvements. Hence, tighter IPRs,
by reducing imitation, may shift innovation away from improvement in existing
products toward development of new products. The overall effects on innovation
and FDI are then unclear.
While these models are insightful there are, however, three drawbacks:
(1) they don’t study the nature of innovation and the resulting market structures;
(2) the nature and conditions of Southern imitation have not been examined;
(3) North–South strategic behaviour has not been considered. Based on the
existing literature and the heated debate on the effect of tighter IPRs on innovation
and FDI, we build an extended North–South product cycle model. In our model,
North (the US) innovation, South (China) imitation, and FDI are all endogenous.
We predict that whether tighter IPRs benefit the US or China depends crucially
on market structure. In an oligopoly market induced by vertical innovation,
tighter IPRs hurt both economies; while in a monopolistic competition market
induced by horizontal innovation, tighter IPRs benefit both economies as long
as the degree of IPRs is appropriately chosen. We prove the existence of an
optimal degree of IPRs protection in China, which may differentiate it from that
in the US.
We contribute to the literature in four critical ways. First, we introduce different
market structures according to the nature of innovation, and discuss the effects
of tighter IPRs on the strategic behaviour between the North and South. Second, we
examine two imitative activities: the horizontal versus vertical imitation (Lazonick
and Mass 1995; Lazonick 2004). Third, we discern the horizontal FDI activities
from the vertical one. Fourth, we illustrate the possible policy implications on the
US–China IPRs conflict, which also holds in the general context of IPRs conflict
between any industrial country and a developing country. The remainder of the
paper is organized as follows. Section 2 presents a general extended North–South
endogenous product cycle model, which can be conveniently used to illustrate the
particular US–China IPRs conflict. Section 3 investigates the effects of tighter IPRs
under different market structures in the South. Policy implications and some
extensions follow in section 4.
256 Z. Zhuang and W. Zou

2. The model
There are two groups (North and South) in the world, where free trade is allowed.
A Northern firm develops a product by incurring an upfront innovation cost. It then
earns the opportunity to make a stream of future profits. It is assumed that the
efficiency of Southern labour in innovation is so much lower than that of Northern
labour, in equilibrium, that only Northern firms will innovate. There is infinite
patent life in all economies, the patent law enforcement is perfect in the North, but
imperfect in South. Therefore imitation only occurs in the South, not in the North.
Assume that imitation cost is lower than innovation cost. There are two types of
imitation: the horizontal imitation (the illegal activities of copy and pirate) produces
the product with lower quality and lower cost than do MNCs; while the vertical
imitation (the legal indigenous innovation) creates the product with higher quality
and lower cost than MNCs can do.
Labour is the only factor of production, and labour endowment in group i is
Li (i ¼ N, S). Assume that one labour supplies one unit inelastic labour service, which
is used for R&D and production in the North or for imitation and production in the
South. At any time, a number of differentiated products (denoted by n) have been
developed by the North. Each innovation takes the form of creating a new
differentiated product in the economy. In equilibrium, Northern firms will transfer
production to the South through FDI, a process we call ‘multinationalization’.
Since the wage is lower in the South, the Northern firm will stop production in the
North once it has multinationalized.

2.1. Consumer behaviour

Following Grossman and Helpman (1991), assume preferences are identical in the
two groups and a representative consumer chooses instantaneous expenditure EðÞ to
maximize utility at time t:
Z1
U¼ eðtÞ log uðÞd,  4 0 ð1Þ
t

Subject to intertemporal budget constraint

Z1 Z1
rðtÞ
e EðÞd ¼ erðtÞ IðÞd þ AðtÞ, 8t ð2Þ
t t

where  denotes the rate of time preference, r the nominal interest rate, IðÞ
instantaneous income, and AðtÞ the current value of assets. The instantaneous utility
uðÞ is defined by:
Z n 1=

u¼ ½xð j Þdj  ð3Þ
0

where xð j Þ denotes the consumption of good j, and n the number of goods available.
Assume 0 5  5 1. Under the above assumptions, the consumer’s optimization
problem can be reduced to a two-stage problem, where the agent solves a dynamic
optimization problem of allocating E(t) over time, then solves a static optimization
 Journal of Chinese Economic and Business Studies 257

problem of choosing the various xð j Þ subject to a budget constraint of E(t) at time t.

Given expenditure E, the standard solution to the static optimization problem gives:
xð j Þ ¼ pð j Þ" E=P1" ð4Þ
1
where " ¼ 1 is the elasticity of substitution between any two goods, and " 4 1.
pð j Þ denotes the price of good j and P is a price index such that:
Z n 1"
1

P¼ pð j Þ1" d ðjÞ ð5Þ

0

Solving the two-stage problem, the optimal spending rule is given by:
_ ¼r
E=E ð6Þ

2.2. The demand for goods

There are three types of firms: Northern firms ðNÞ, MNCs ðMÞ and Southern
imitators ðSÞ. Denote firms by J, J ¼ N, M, S. Northern firms can either produce
in the North or South. A firm needs one unit of labour service to produce a unit
output in the North, whereas   1 units of labour service per unit output are needed
in the South, due to the costs of coordinating decisions over larger distances and
operating in a relatively unfamiliar environment (Markusen 1995).
At time t, n goods are produced, in which nS and nN are produced in the South
and North respectively. Let nS ¼ nI þ nM , where nI are MNCs’ products imitated
by Southern imitators, and nM are products produced in the South by MNCs.
We assume constant returns to scale in the production of each good. There are no
fixed costs of production per period, nor are there transportation costs. Each
product is developed and produced by a different firm. Firms compete with each
other by setting prices. Because of the symmetry of all goods in the demand function,
let xN be the demand for any good produced by a Northern firm, xS the demand
for any good produced by a Southern firm, and xM the demand for any good
produced by a MNC. The variables xN , xS and xM are determined by demand
function (4) when the prices of the n goods are known. Assume transportation cost is
zero and there are no trade barriers, and the goods can always be sold in the world
market. Let N be the instantaneous profit of a Northern firm, M be that of a MNC
whose product has not been imitated at that instant, and S be the instantaneous
profit of a Southern firm. Wage rates in the North and South are denoted by wN and
ws respectively; similarly, labour supply is denoted by LN and LS respectively.
Given the demand function in equation (4), it is easy to show that prices
of Northern firms are mark-ups over their marginal costs:
pN ¼ wN =, pM ¼ wS = ð7Þ
Southern firms can only produce those goods that they have been imitated
successfully, and a firm needs one unit of labour service to produce a unit output.
We assume that imitation targets MNCs.2 A Southern imitator engages in price
competition with the MNC, and in equilibrium we have:
pS ¼ wS ð8Þ
258 Z. Zhuang and W. Zou

Let xJ (J ¼ N, M, S) denote the output level of firm. From equation (4) we have:
xðiÞ=xð j Þ ¼ p" "
i =pj ð9Þ

From equations (7) and (8), we then have:

xS =xM ¼ " ð10Þ

xM =xN ¼ ½wS =wN " ð11Þ

Hence, the profit flows of a Northern firm, a MNC and a Southern firm are as
follows:
N ¼ ð pN  wN ÞxN ¼ ð1  ÞwN xN = ð12Þ

M ¼ ð pM  wS ÞxM ¼ ð1  ÞwS xM = ð13Þ

S ¼ ðwS  wS ÞxS ¼ ð  1ÞwS xS ð14Þ

2.3. Innovation, imitation and FDI

Assume the rate of invention per unit time n_ is given by:
n_ ¼ Ln Kn =aN ð15Þ
where aN is a parameter of innovation productivity, and Ln is Northern skilled
labour used in innovation. Kn is an accumulative knowledge stock used in
innovation, where Kn ¼ n, reflecting the spillover effect of past innovations on
current ones. We therefore define g ¼ Ln =aN . In the North, labour is allocated
to innovation and production as follows:
aN g þ nN xN  LN ð16Þ
Imitation is assumed costly, yet the costs of imitation are averagely around 65%
of innovation costs (Mansfield, Schwartz, and Wagner 1981). Similarly, the rate of
imitation per unit time is given by:
n_ I ¼ LSI KS =aI ð17Þ
where aI is a parameter of imitation productivity, and LSI is Southern labour used
in imitation. KS is an accumulative stock of knowledge used in imitation, and
KS ¼ nS . The imitation rate is:
i ¼ n_I =nM ¼ nS LiSI =nM aI , i ¼ 1, 2 ð18Þ
where subscript i denotes vertical or horizontal imitations, and vertical imitation
needs more labour than that of horizontal imitation, i.e. L2SI 4 L1SI .
We make a distinction between two types of FDI: horizontal FDI (an expansion
of production of existing goods), and vertical FDI (introduction of new goods
and an expansion of product differentiation). We thus define the rates of horizontal
and vertical FDI as follows:

1 ¼ nM pM xM =nS pS xS ð19Þ
 Journal of Chinese Economic and Business Studies 259

2 ¼ n_ M =nN ð20Þ
Accordingly, Southern resources constraints can be written as:
aI n_ I =nS þ nM xM þ nI xS  LS ð21Þ
Southern labour is allocated to imitation, production of MNCs, and production
of Southern firms.

2.4. Steady state

Like Helpman (1993), Lai (1998), and Branstetter et al. (2007), we study a steady
state equilibrium in which r ¼  is satisfied, and all product categories grow at the
same rate g. We thus have:
_ ¼ n_ N =nN ¼ n_ I =nI ¼ n_ M =nM ¼ n_ S =nS
g  n=n ð22Þ
Combining equations (22), (20) and (18), we have:
nM =nN ¼ 2 =g, nS =nN ¼ 2ð g þ i Þ=g2 , i ¼ 1, 2 ð23Þ

nI =nM ¼ i =g, n=nN ¼ 1 þ 2ð g þ i Þ=g2 , i ¼ 1, 2 ð24Þ

A successful innovator can produce either in the North or South. It is cheaper to
produce in the South, where the risk of being imitated is higher. The lifetime value of
a successful innovator producing in the North and that of a MNC are as follows:
vN ¼ N =ð þ gÞ ð25Þ

vM ¼ M =ð þ g þ i Þ, i ¼ 1, 2 ð26Þ
N M
Because any Northern firm is free to become a MNC, v ¼ v holds. Similarly, the
lifetime value of a Southern producer is:
vS ¼ S =ð þ gÞ ð27Þ
Free entry of innovation implies that the value of a Northern firm must be exactly
the cost of innovation. Similarly, imitation in the South is competitive. We thus have:
N =ð þ gÞ ¼ wN aN =n ð28Þ

S =ð þ gÞ ¼ wS aI =nS ð29Þ

We now examine the North–South relative wage. Since vN ¼ vM holds, we have:
M =N ¼ 1 þ i =ð þ gÞ, i ¼ 1, 2 ð30Þ
From equations (12) and (13), we also have:

M =N ¼ ½wS =wN 1" ð31Þ

Combining equations (30) and (31), we have:
1
wN =wS ¼ ½1 þ i =ð þ gÞ"1 , i ¼ 1, 2 ð32Þ
260 Z. Zhuang and W. Zou

Obviously, given the parameters, the North–South relative wage depends on  and g.
In a steady state, from equations (16), (23) and (24), the labour market-clearing
condition in the North is:
g2 aN ð þ gÞ
aN g þ ¼ LN , i ¼ 1, 2 ð33Þ
g2 þ 2 ð g þ i Þ ð1  Þ
Similarly, from equations (21), (23) and (24), the condition of labour market clearing
in the South is:
gi g aI  i aI ð þ gÞ
aI þ þ ¼ LS , i ¼ 1, 2 ð34Þ
g þ i ð g þ i Þ ð  1Þ" i þ g ð  1Þ
From equations (28), (29), (12) and (14), profit maximization of firms implies:
n aI ð1  ÞxN
¼1 ð35Þ
nS aN ð  1ÞxS
From equations (10), (11) and (32), the North–South relative wage implies:
 "
nS aN 1" ð  1Þ  þ i þ g "1
¼ 1, i ¼ 1, 2 ð36Þ
n aI ð1  Þ þg
Combining equations (23) and (24), all product categories grow at the same rate,
which implies:
 "
2 ð g þ i Þ aN 1" ð  1Þ  þ i þ g "1
¼ 1, i ¼ 1, 2 ð37Þ
g2 þ 2 ð g þ i Þ aI ð1  Þ þg
Equations (33), (34) and (37) define the steady state equilibrium of the model
in terms of four endogenous variables: the rate of innovation, the imitation rate,
the rate of FDI and the supply of skilled labour in South.

3. Market structures and the effects of IPRs protection

To examine the effects of IPRs protection, we define the cost of imitation as
aI ð1 þ Þ, where 2 ½0, 1. A higher represents a higher degree of IPRs protection,
and vice versa.

3.1. Imitators’ strategic choice under weak IPRs protection

Suppose IPRs protection is weak ( ! 0), will an imitator choose horizontal or
vertical imitation? If the imitator chooses and succeeds in vertical imitation, given
MNCs’ strategies, he produces a product of higher quality and lower cost than
MNCs can do. Because of the free-rider problem (all Southern firms can costlessly
produce the imitated products) the economy will return to the steady state defined
above. From equation (29), we know that the expected return of the imitator
deteriorates, i.e.:
ð  1ÞwS xS =ð þ gÞ ¼ wS aI =nS 5 wS aI ð1 þ L2SI Þ=nS ð38Þ
 Journal of Chinese Economic and Business Studies 261

where L2SI 4 0 is Southern labour used in vertical imitation. No rational imitator

chooses vertical imitation strategy (2 ), and horizontal imitation (1 ) is thus the
imitators’ dominant strategy.
PROPOSITION 1 Horizontal imitation (1 ) is the imitators’ dominant strategy under
weak IPRs protection.

3.2. Imitators and MNCs’ strategic choice under tighter IPRs protection
If the South strengthens IPRs protection, what would be the optimal strategies
of imitators and MNCs? Other things being equal, we introduce IPRs protection into
equation (34) and find out its effect on imitation as follows:
@i =@ ¼ aI ðg" þ i g þ i Þ= , i ¼ 1, 2 ð39Þ
where the denominator is ¼ gðg þ   " ÞaI ð1 þ Þ=ð g þ i Þ, and the numerator
aI ðg" þ i g þ i Þ 5 0. Obviously, the degree of market power (measured by
1=, Aghion and Howitt 1992) plays a crucial role here. If 1= ¼ ½ð þ gÞ=1=" ,
then ¼ 0. Therefore, whether tighter IPRs protection will induce higher or lower
imitation depends on the structure of the market in which imitator and MNCs
operate. More specifically, if market power is low, i.e. 1= 5 1= , then 5 0,
@i =@ 4 0, more imitation will occur as a result of tighter IPRs protection;
otherwise, if 1= 4 1= , then 4 0, @i =@ 5 0. We therefore get Proposition 2.
PROPOSITION 2 Under tighter IPRs protection in the South (China), imitation may
increase or decrease according to the degree of market power.
Our further research will be focused on the oligopoly or monopolistic market,
which is induced by vertical or horizontal innovation, respectively.

3.2.1. Oligopoly market, vertical innovation and tightening IPRs

In an oligopoly market with vertical innovation, when the South strengthens IPRs
protection, other things being equal, equation (29) can be rewritten as:
S =ð þ gÞ 5 wS aI ð1 þ Þ=nS ð40Þ
The profit of imitation obviously decreases, which in turn constitutes imitation
disincentives (Glass and Saggi 2002). Will an imitator choose horizontal or vertical
imitation?
Assume Northern products are generated by vertical innovations, the imitator
engages in a Betrand price competition with the MNCs. If the imitator chooses
and succeeds in vertical imitation, the economy will go back to the steady state
defined by (33), (34) and (37) as long as MNCs choose vertical FDI. As such, the
expected return of the imitator will be less than its costs:
ð  1ÞwS xS =ð þ gÞ 5 wS aI ð1 þ L2SI Þ=nS 5 wS aI ð1 þ L2SI Þð1 þ Þ=nS ð41Þ
Therefore, a rational imitator will not choose a vertical imitation strategy.
Suppose MNCs choose horizontal FDI, the imitator engages in another Betrand
price competition, in which the imitator will make price so low based on its lower
262 Z. Zhuang and W. Zou

costs that MNCs will then be driven out of the market, and the net profit of the
imitator will be:

ð=  1ÞwS xS =ð þ gÞ  wS aI ð1 þ L2SI Þð1 þ Þ=nS

Other things being equal, the net profit is determined by 1=, L2SI , , and it is thus
uncertain. However, by choosing vertical FDI, MNCs get positive profit:

M ¼ ð1=  1ÞwS xM 4 0 ð42Þ

From equations (25) and (27), we have:

ð þ ÞwS xM wN xN
vM  vN ¼  ð43Þ
 þ g þ 2 þg
As long as 2 is not very big, there exists a critical 2 such that vM ¼ vN . Thus,
a rational MNC chooses vertical FDI, and a rational imitator chooses horizontal
imitation strategy (1 ). From equation (39) we have:
@1 =@ ¼ aI ðg" þ 1 g þ 1 Þ= ð44Þ
Similarly, the effect of IPRs protection on horizontal imitation depends on the
degree of market power. We summarize what we have in Corollary 1.
COROLLARY 1 In oligopoly markets with vertical innovation in the North (US), there
exists a critical value of market power such that if 1= 4 1= , then @1 =@ 5 0. Thus
the imitation rate 1 decreases with the tightening of IPRs protection, and the number
of products produced by Southern (China) firms (nI ) decreases.
Given the imitator’s horizontal imitation strategy, from equations (25) and (26),
we have vM 4 vN . What actions will MNCs take? Generally speaking, MNCs have
two strategies: horizontal FDI ( 1 ) and vertical FDI ( 2 ). Assume the value of 1 is
vM M M M
1 , the value of a potential entrant 2 is v2 . If v1 4 v2 , then MNCs will choose 1 .
However, even if v1 5 v2 , the net value of choosing 2 will be vM
M M M M
2  v1 5 v2 .
Therefore, a rational MNC chooses 1 , instead of 2 , before its monopoly power
disappears (Aghion and Howitt 1992; Grossman and Helpman 1991). By choosing
1 , MNCs hire more Southern labour and extend production of existing products,
thus the rate of introducing new products (i.e. 2 in equation (20)) decreases, and the
number of products produced by MNCs (nM ) decreases.
What will be the effect on Northern innovation? On one hand, as 2 and nM
decrease, the demand for innovation decreases, the number of products produced
by Northern firms (nN ) will then increase, which in turn increases labour used in
Northern production and reduces labour used in innovation. On the other hand,
tighter IPRs protection reduces the imitation rate, and increases profitability of
innovation. We compute from equation (33) to get:

@g=@ 2 ¼ ð1 þ 1 =gÞðLN  aN gÞ= ð45Þ

N ðþ2gÞ N 1
where ð1 þ 1 =gÞðL  aN gÞ 4 0, ¼ aN ð 2 þ 2g þ þL ð  1Þ.
1 Þ 2 g2
Therefore equation (33), we have 4 0, and @g=@ 2 4 0. Since the rate of 2
decreases, the rate of innovation g decreases.
 Journal of Chinese Economic and Business Studies 263

We then examine North–South relative wage in equation (32). Given the rate
of innovation g, when imitation rate 1 decreases, wN =wS decreases as a result. As for
the allocation of North–South manufacturing in equation (23), given g, nS =nN
decreases with the decrease in 1 , 2 . We conclude with the following Corollary.
COROLLARY 2 In oligopoly markets with vertical innovation in the North (US), if the
South (China) firm chooses horizontal imitation, then the North (US) MNCs choose
a horizontal FDI strategy, and the innovation rate in the North (US) decreases. Given
innovation in US, the tightening of IPRs in the South (China) will result in lower
imitation, lower wN =wS and lower nS =nN .

3.2.2. Monopolistic competition market, horizontal innovation and tightening IPRs

Under monopolistic competition with horizontal innovation in the North (US),
we consider what strategies a South (China) imitator will take, and what will be
the effect of tighter IPRs. From the above analysis, independent of MNCs’ strategy,
the net marginal return of imitation strategy 2 is bigger than that of imitation
strategy 1 :
p  wS 4 ð  1ÞwS 4 0 ð46Þ
where wS 5 p 5 wS =. Apparently, under the following condition, the imitators
chooses strategy, 2 , and from monopolistic competition with MNCs:
ð p  wS ÞxS wS aI ð1 þ L2SI Þð1 þ Þ wS aI ð1 þ Þ
 4 ð47Þ
þg nS nS
In this case, the imitators choose strategy 2 and have to overcome the imitation
disincentive effect and the resource wasting effect resulting from the increased
difficulty in imitation (Glass and Saggi 2002). If equation (47) holds, it implies the
following marginal condition.
p=wS  1 =  1
ð1 þ Þ  5 ð48Þ
ð þ gÞaI ð1 þ L2SI Þ ð þ gÞaI ð1 þ L2SI Þ
where wS 5 p 5 wS =. In the limit case, ! 0, from Proposition 1 we know the
imitators choose strategy 1 , thus has a lower bound . From equation (48), there
exists an optimal value of  so that the imitator can set a price p 2 ½wS , wS = and
equation (48) continues to hold. Thus, the imitators choose strategy 2 .
Furthermore, from above we have d  =dp 4 0, dp =d 5 0, and p has an upper
bound, thus  has an upper bound, i.e.  5 ½ð=  1Þ=ð þ gÞaI ð1 þ L2SI Þ  1 ¼  .
Therefore, the optimal value of  depends on a range of parameters, such as the
degree of market power (1=), the coordination efficiency of MNCs, the imitation
efficiency, the rate of time preference and supply of skilled labour in the South
(China). All parameters differ between North (US) and South (China), which implies
that there will be different optimal degrees of IPRs protection.
PROPOSITION 3 Given monopolistic competition induced by horizontal innovation in
the North (US), there exists an optimal degree of IPRs protection 5  5  in the
South (China), which may differ from that in the North (US).
264 Z. Zhuang and W. Zou

Table 1. Effects of IPRs protection under different market structures.

Monopolistic
Oligopoly competition

Horizontal imitation rate 1 Decrease /

Vertical imitation rate 2 / Increase
Horizontal FDI 1 Increase /
Vertical FDI 2 Decrease Increase
Rate of innovation g Decrease Increase
Ratio of South–North manufacturing nS =nN Decrease Increase
North–South relative wage wN =wS Decrease Increase

We can also conclude that there exists a pair of ð  , p Þ satisfying equation (48).
In other words, the incentive for vertical imitation is high enough to overcome
disincentive from higher imitation difficulty. Because of the nature of monopolistic
competition, there exists a critical value of market power in equation (39) such that
if 1= 5 1= , then @2 =@ 4 0. Therefore, the imitation rate 2 increases, and the
number of products produced by Southern firms nI increases.
Given the imitators’ vertical imitation strategy, we have vM 5 vN , the profitability
of MNCs decreases. What strategies will MNCs take? From the above analysis,
we know that if MNCs choose a horizontal FDI strategy 1 , it will be driven out
of the market. If MNCs choose vertical FDI strategy 2 , the profit of a typical MNC
will be:
0 5 p  wS 5 ð1=  1ÞwS
where wS 5 p 5 wS =. The rational MNC hence chooses strategy 2 . And the
number of products produced by MNCs nM increases with the increase in 2 .
What is the effect on Northern innovation? From equation (45) we know that
@g=@ 2 4 0, which implies an increase in the innovation rate g due to the increase
in 2 . From equation (32), and given g, the North–South relative wage wN =wS
increases when imitation rate 2 increases. Similarly, we conclude from equation (23)
that, given g, the ratio of South–North manufacturing nS =nN increases with the
increase in 2 and 2 . Table 1 and Proposition 4 summarize our findings about
the effects of tighter IPRs protection under different market structures.
PROPOSITION 4 In oligopoly markets due to vertical innovation, tighter IPRs in the
South (China) hurts both groups in that both the South (China) imitation rate and the
North (US) innovation rate will decrease, while in a monopolistically competitive
market due to horizontal innovation, tighter IPRs in the South (China) will benefit
both groups in that both vertical imitation in the South (China) and innovation in the
North (US) will increase.

4. Conclusions
We build an extended North–South product cycle model in which innovation,
imitation, and FDI are all endogenous. We extend existing models and shed light on
the hotly debated US–China IPRs conflict. Our model differs from earlier models
 Journal of Chinese Economic and Business Studies 265

in the following ways: we take into account the strategic behaviour of Northern
and Southern firms as well as MNCs; we discern horizontal FDI from vertical FDI,
horizontal from vertical innovation, horizontal from vertical imitation so that the
market structure can be well defined and analyzed; we study the effects of tighter
IPRs protection in the South on both groups and investigate the optimal IPRs
in different countries.
We find that whether tighter IPRs will hurt or benefit both groups depends
on a range of parameters, among which market structure makes a huge difference.
The overall effect of tighter IPRs in the South (China) on FDI of the North (US) is
uncertain, which is consistent with the substantial empirical results (Bronckers 1994;
Chang 1998; Helleiner 1989; Lall 1993; McCalman 2001, 2004, 2005a, 2005b; Siebeck
et al. 1990; UNDP 1999). What we conclude from our model presents theoretical
foundations for the empirical findings on industry-specific or country-specific
FDI (Lee and Mansfield 1996; Mansfield 1995; Maskus 2000).
The policy implications of our model are straightforward. (1) The South (China)
should make weaker IPRs protection in oligopoly markets with vertical innovation,
because, in these markets, tighter IPRs protection in the South (China) will increase
North (US) horizontal FDI, but decrease vertical FDI, and hurt both sides by
reducing rates of both imitation and innovation. (2) The South (China) can make
tighter IPRs protection in monopolistically competitive markets with horizontal
innovation, because in this case tighter IPRs protection will increase vertical FDI,
and stimulate more vertical imitation in China and more innovation in the US.
(3) There exist different optimal degrees of IPRs protection across nations.
Appropriate industry-specific IPRs policy should be implemented and may benefit
both the US and China.
The theoretical framework developed in this paper can be extended in multiple
ways in further research. First, one can examine the effects of tighter IPRs on the
welfare of the North (US) and South (China). Second, one could study how tighter
IPRs may affect inequality within and across nations by taking into account low
and high-skilled labour. Third, one could explain differences in technology
upgrading and growth across industries in the South (China) through introducing
endogenous innovation encouraged by tighter IPRs. Four, the effects of tariffs,
technology transfers, and international labour migration could also be studied using
this framework.

Acknowledgements
We are grateful to the National Science Foundation of China (Grants 70673072), National
Social Science Foundation of China (Grants 06BJL048) and the New Century Intellectual
Program (2007) of Chinese Educational Ministry for financial support. Helpful suggestions
from Ping Wang (Washington University in St. Louis) are deeply appreciated. Nonetheless,
the authors are solely responsible for any errors.

Notes
1. The North refers to the group of all industrial countries, which are mostly located in the
Northern hemisphere, while the South refers to the group of developing countries, most of
266 Z. Zhuang and W. Zou

which are located in the Southern hemisphere. As the largest country in the North
group, the US typifies this group while China is a typical representative of the
South group and the largest South country, although it happens to be located in the
North geographically. Many models of North–South trade have been built, such
as Grossman and Helpman (1991), Helpman (1993), Lai (1998), Glass and Saggi (2002),
among others.
2. Actually, Northern firms may possibly have their products imitated, but the risk of
imitation they face is lower than that of MNCs (Glass and Saggi 2002).

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