technological innovation and multinational expansion: a two-way link?

Vol. 68 (t998), No. 1, pp. 1-26 Journal of Economics Zeitschrift for National6konomie

�9 Springer-Verlag 1998 - Printed in Austria

Technological Innovation and Multinational Expansion: a Two-way Link?

Maria Luisa Petit and Francesca Sanna-Randaccio

Received July 10, 1997; revised version received March 19, 1998

The paper examines how investment in research influences the form of foreign expansion chosen by the firm, and vice versa. We consider a two-country model where a monopolist producing in one country can choose between export and foreign direct investment. We assume process innovation, where the cost-reducing technological innovations are an outcome of the firm's investment in R&D. The role of technology transfer costs is explored. The model shows that, with low costs of technology transfer, there is a two-way link between the firm's R&D effort and multinational expansion. We also prove that both the research choice and the multinational choice have a positive effect on consumers' welfare in both countries.

Keywords: technology, trade, foreign direct investment, multinational company.

JEL classification: F23, L12, 033.

1 Introduction

The multinational expansion of firms and the process of technological innovation are key determinants of the rapid transformation of the world economy. Foreign direct investments (FDI) grew at an explosive pace in the second half of the 1980s and, after a slow-down in the early 1990s, are again accelerating (UNCTAD, 1994, p. 231). They tend to be concentrated in the technologically most advanced sectors (Dunning, 1993, p. 29; Ostry and Gestrin, 1993, p. 9). Large international firms, on the other hand, control a high proportion of world trade in technology-intensive industries (Bonturi and Fukasaku, 1993). Thus, in these areas, increasingly international trade and FDI are modes of foreign expansion undertaken by the same agents - the multinational companies (MNEs) - which in tum are the principal generators of new technologies

M. L. Petit and F. Sanna-Randaccio

through research and development (R&D) and play a major role in the international transfer of technology.

The large body of literature analyzing the relationship between technological innovation and multinational expansion presents several shortcomings. The analyses conducted in the 1970s focused on a one- way causation chain going from R&D to multinationality. These studies were influenced by the static structure-conduct-performance approach, at the time the prevailing paradigm. Then Mansfield et al. (1979) pointed to the reverse causal chain, as they found that for large US companies overseas sales opportunities had the effect to increase the R&D effort. And Hirschey (1981) maintained that R&D investment and international expansion reinforce each other, thus highlighting the existence of a two-way relationship between these two phenomena. These authors, however, did not make a clear distinction between different modes of foreign expansion and their impact on innovation. In the 1980s and 1990s the interaction between innovation and multinational expansion has been stressed by several authors following the evolutionary approach (for instance Cantwell, 1989; Zander, 1991, etc.). These studies, although offering many interesting insights, do not provide a formal analysis.

As to the formal literature, the interaction between different modes of foreign expansion and technological innovation has not yet been analyzed. The relevant formal models can be subdivided in three groups. First, models which study the effects of technological innovation on production and welfare by considering firms producing within a sin- gle economy, therefore ignoring any problems related to firms' foreign expansion (e.g., Kamien and Schwartz, 1982; d'Aspremont and Jacquemin, 1988; Petit and Tolwinski, 1996, 1998). Second, models which examine the choice of the modality of foreign expansion but do not take into account the effects of technological innovation (Motta, 1992; Sanna-Randaccio, 1996) or consider technology as an important but exogenous factor in the process of internationalization of production (Horstmann and Markusen, 1992). Third, models which examine firms' R&D decisions within an international setting, however, assuming the modality of foreign expansion as given (Spencer and Brander, 1983; Cheng, 1984; De Bondt et al., 1988; Veugelers and Vanden Houte, 1990; Wang and Blostrom, 1992).

Our paper is the first attempt in the literature to provide a formal model analyzing a firm which takes decisions on whether to expand abroad through exports or foreign direct investment and also on both R&D investment and the level of output. It integrates the different branches of the literature just considered. With such a model we are able to examine the influence of the form of foreign expansion chosen by

Technological Innovation and Multinational Expansion 3

the firm on the R&D decision, and also how this last choice influences the firm's decision on how to expand abroad.

We present a two-country model where a monopolist producing in one country has the possibility to serve the other country either by exporting or by creating there a new plant. The production process is characterized by increasing returns to scale and we consider process innovation, where the cost-reducing technological innovations are an outcome of the firm's investment in R&D. The model describes a sit- uation in which the firm must take three different types of decisions: (i) whether to export or to invest abroad, (ii) how much to invest in R&D, (iii) how much to sell in each market. These choices are initially analyzed assuming that the parent company is able to transfer at no cost its technological knowledge to its foreign subsidiary, and then by considering imperfect transferability. Since we take into account an innovator which serves two countries comparable in size, the analysis best applies to economic relationships between developed markets. The equations of the model are kept as simple as possible in order to be able to obtain analytical solutions and to compare the different results.

We prove that with low costs of technology transfer there is a two- way relationship between R&D and foreign expansion via FDI, in the sense that FDI is more likely to take place if the firm invests in R&D than if it does not, and that, on the other hand, the optimum level of R&D is higher when the firm produces abroad instead of exporting. We also show the effect of past accumulated knowledge and of country size on R&D investment and on the firm's foreign expansion. Finally, the welfare implications of the different choices made by the firm are also analyzed.

The paper is organized as follows. In Sect. 2 the model is described and in Sect. 3 the interaction between R&D and the mode of foreign expansion is analyzed assuming perfect knowledge transferability. Section 4 examines the role of technology-transfer costs. In Sect. 5 the effects of R&D expenditure and of the mode of foreign expansion on social welfare are discussed. Section 6 shows how changes in the technology parameters affect the regions defining the export and FDI equilibria. Finally, Sect. 7 concludes the paper.

2 The Model

We construct a simple model with one firm and two identical countries (the home and the foreign country). We thus assume a firm which en- joys a monopoly position in the world market (due, for instance, to the discovery of a new product).

M.L. Petit and F. Sanna-Randaccio

The firm invests in R&D to lower its production costs. Learning resulting from investment in R&D characterizes the production process, implying that marginal (and unit) costs decrease as investment in R&D increases. That is, we consider process innovations that result in reductions in production costs. R&D investment is here modeled as a centralized activity which is carried out taking into consideration the firm as a whole, therefore by evaluating its impact on the finn's global profit, as suggested by several studies (e.g., Mansfield et al., 1979).

Let I be the level of research undertaken by the monopolist and let r e ( I ) denote the firm marginal cost. The function m ( I ) represents the (negative) relation between marginal cost and the innovations generated by R&D investment. More specifically 1

m ( I ) = A - O I , (1)

where A can be considered as the initial marginal cost of production, in other words the cost that will prevail with no investment in R&D. The value of A can be seen as the result of past accumulated knowledge. Hence, A can be considered as inversely related to the firm's technological competence. The parameter 0, with 0 > 0, determines the rate at which m declines with an increase in the R&D level. It shows the productivity of the firm's research effort. The specification of cost-reducing innovation adopted here can be easily extended to the case of product innovation, where R&D investments shift the intercept of the demand curve upwards as in De Bondt et al. (1988) and Veugelers and Vanden Houte (1990).

On the demand side, we consider linear (inverse) demand functions 2 for the home country h and for the foreign country f:

Ph = a -- b h X h and p f = a - b f X f , (2)

where Xh and Xf denote sales in the home country and in the foreign country respectively. The parameters a , bh, b f are positive constants

1 For a similar specification see d'Aspremont and Jacquemin (1988) and Wang and Blomstrom (1992), who assume 0 = 1.

2 The analysis has also been undertaken with a nonlinear model, characterized by nonlinear demand and marginal-cost functions. Since analytical results are not possible to obtain in the nonlinear case, numerical solutions have been computed for a wide range of values of the parameters. The results obtained in the nonlinear case fully confirm those of the linear model. The nonlinear-model numerical results may be obtained on request from the authors.


and 1 / b h (1/bf) measures the size of the market of the home (foreign) country. For sake of simplicity, it is assumed that bh = bf, thus the subscripts will be omitted as to the market-size parameters.

The main assumptions are the following:

A.1. I < A / O ;

A.2, X i <_ a / b , X i > 0, i = h, f; A.3. a > A > 0 .

Assumption 1 guarantees the nonnegativity of marginal costs. Assump- tion 2 guarantees nonnegative prices while Assumption 3 ensures that the firm will be active.

The monopolist produces in the home country and, in order to serve the foreign country, can choose either to export the good with additional marginal (and unit) transport cost 3 s, or to start a new plant in the other country, with additional plant-specific fixed cost G. Thus export is the high-marginal-cost and low-fixed-cost option, while the reverse is the case for FDI.

Monopolistic profits will differ depending on the mode of foreign expansion considered. That is:

Case a: Exporting monopoly. The firm has only one plant and exports to the other country. Profits are then given by:

Jr E = (a -- b X h ) X h + (a - b X f ) X f - ( A - O I ) X h (3)

- ( A - O I + s ) X f - F I 2 / 2 - G ,

where FI2/2, with F > 0, is the cost of investment in R&D, in other words it is the total R&D expenditure of the monopolist (R&D performed at the parent level as well as by the subsidiary). The quadratic form indicates the possibility of diminishing returns to R&D expenditure (see, e.g., Cheng, 1984). The parameter F is inversely related to the firm's cost effectiveness in R&D. R&D expenditure is thus modeled as a firm-specific fixed cost (i.e., it does not depend on output). But differently from Horstman and Markusen (1992) here R&D expenditure is endogenously determined.

Case b: Two-plant monopoly. The firm creates a production subsidiary in the foreign country, i.e., becomes an MNE. Since we are considering two identical developed countries, we initially assume that the firm is able to transfer costlessly its knowledge to the foreign sub-

3 A unit tariff (or NTB) may be included in the model as an increase in the parameter s. Thus s captures both transport costs and policy-induced discrimination.


sidiary, as in De Bondt etal. (1988) and Veugelers and Vanden Houte (1990). 4 Profits are then given by:

re D = ( a - b X h ) X h q- ( a - - b X f ) X f

- ( A - O I ) ( X h q- Xf) - ] / 1 2 / 2 - - 2 G . (4)

The optimal values of sales in each country and of investment in R&D by the monopolist are obtained as the result of the maximization of each of the above profit functions.

3 The Interaction between R&D Investment and the Mode of Foreign Expansion

The early studies on MNEs generally suggested that the relationship between innovation (here captured by investment in R&D by the firm) and international expansion via FDI is one-way, i.e., that the causation chain goes from innovation to multinational expansion. 5 Hymer (1976), for instance, maintains that there are barriers to internationalization and that the investing firm in order to face such extra costs must enjoy some kind of advantage over local producers. According to this author, such ex ante advantage might take the form of special technological skills. The idea that innovation precedes and causes the firm's multinational- ization has remained the prevalent view in the 1970s, although since an early period some authors pointed to the presence of a feedback from international production to technological innovation (see, e.g., Reddaway, 1968; Mansfield et al., 1979). The existence of a two-way relationship between R&D investment and multinational status was initially stressed by Hirschey (1981) who maintains that these two phenomena reinforce each other. In the late 1980s and in the 1990s, due mainly to authors in the evolutionary tradition (for instance, Cantwell, 1989; Zander, 1991) the attention has shifted to the analysis of a two-way causation link between innovation and international production.

Here we want to contribute to this debate, showing under which conditions a formal analysis of the problem gives support to the hypothesis of a two-way relationship.

4 The case of positive technology-transfer costs will be discussed in Sect. 4.

5 This led to several econometric analyses (reviewed by Caves, 1982, p. 9) which confirmed the importance of R&D investment as a determinant of MNE involvement.


3.1 The Effect o f the Mode of Foreign Expansion on the R&D Investment Decision

Let us consider the R&D and output decisions under two scenarios, export and FDI. For sake of clarity of exposition, we will start from FDI, i.e., case b.

Case b: Two-plant monopoly. We assume here that the monopolist expands abroad by creating a subsidiary in the foreign country, that is by becoming an MNE.

From first-order conditions we get:

a - A + O I Xh = Xf - , (5)

2b

which describes the (positive) relationship between the optimal level of output and investment in R&D. Higher R&D induces lower marginal (and unit) cost, and thus higher production, given the demand functions.

The optimal levels of investment in R&D and of sales at home and abroad for the MNE are given by:

}D _ O(a -- A) by - 0 2 ' (6)

^ ^ y (a - A) X ~ = X ~ - 2 ( b v - O 2 ) ' (7)

where, from second-order conditions, by > 02. We find that investment in R&D, and thus the level of output, in-

creases with the technological competence of the firm (negatively related to the initial marginal cost A), with the firm's R&D cost effectiveness (inversely related to y) and with the PrOductivity of R&D (proxied by 0). Such results, which underline the continuity in the innovative process, seem to be in line with the second Schumpeter (1943) but contradict the first Schumpeter (1934). 6 Furthermore (6) shows that the larger the size of the two countries the more the firm will innovate. In fact }D is a positive function of (i /b), the market-size parameter.

Obviously the output price (in this case the same at home and

6 The "first Schumpeter" analyzes a stage of capitalistic development, which he defines as Competitive Capitalism, in which innovations are typically introduced by new firms, thus underlining the discontinuity in the process of innovation. The "second Schumpeter" recognizes that the market has become more concentrated, i.e., what he calls Tmstified Capitalism has prevailed, and innovations have become essentially the concern of large producers already in the market.


abroad) is a decreasing function of the initial demand-cost margin (i.e., the difference between the demand intercept a and the initial marginal cost A), of market size, and of the firm's R&D cost effectiveness and R&D productivity, that is:

/ ~ D = / 3 D = a _ b F ( a - a ) 2 ( b y - 0 z) " (8)

Profits of the MNE are thus given by:

7~ D __ y ( a -- A) 2 2G . (9) 2 ( b y - 0 2)

Case a: Exporting monopoly. We now assume that the monopolist expands abroad by exporting the output produced at home.

From first-order conditions we now get:

[ E _ O ( a - - A ) Os (10) b y - 02 2 ( b y - - 02) '

^ g ( a - A ) 02s (11) x E - - 2 ( b y - 0 2) 4 b ( b F - 0 2) '

^ F ( a - A ) s ( 2 b y - 02 ) XfZ - 2 ( b y - 02) 4 b ( b g - 02) '

(12)

where, again from second-order conditions, b y > 0 2.

It can be easily seen that investment in R&D is lower in this case. Also sales at home and abroad are lower than in the previous case (with foreign sales decreasing more than home sales), as well as ag- gregate output. The price levels both in the home and foreign markets are consequently higher (with pf > Ph), i.e.:

F (a - A ) 0 2 S ~ E = a - b +

2(by - 0 2) 4(bF - 0 2) '

y ( a - A ) s ( 2 b y - 0 2 ) = a - b +

2 ( b y - 0 2) 4(bF - 0 2)

(13)

(14)

Profits are now given by:

~r E v ( a -- A) 2 F s ( a - A ) s 2 ( 2 b y - 02) - - +

2 ( b g - 02) 2 ( b y - 02) 8 b ( b ~ ' - 02) G . (15)


Variable profits, net of R&D expenditures, are higher for the MNE than for the exporting firm, since (for the proof see Appendix A)

s 2 - ~ ( a - A) > ~-~(2bg - 02) (16) o

Global profits will also be higher for the MNE iff:

y S 02S 2

4(bv - 02) [2(a - A ) - s] + 8 b ( b y - 02) > G . (17)

That is, if the additional variable profits due to the FDI choice as compared to export, net of R&D expenditure, [left-hand side of (17)] more than compensate the additional fixed cost due to the new plant (G).

We can now state the following proposition:

Propos i t i on 1: The level of R&D investment is higher if the firm becomes an MNE rather than an exporter.

Taking the difference between Eqs. (6) and (10) we can observe that investment in R&D is higher in the case of FDI by the amount O s / 2 ( b y - 02). The difference in the equilibrium levels of R&D is a positive function of (i) transport costs (the parameter s), (ii) market size (i.e., is inversely related to b), (iii) the R&D-cost effectiveness of the firm (which is inversely related to y) and the R&D productivity (proxied by 0).

This result can be better understood if we examine the relation between profits and R&D investment, i.e.,

7rD(I) = ( a - - A + 0 1 ) 2 V I 2 2 G (18) 2b 2

for the firm that expands via FDI, and

7t "E---(I) (a -- A + 01 ) 2 (a - A + OI - s ) 2 VI 2 = + G (19) 4b 4b 2

for the firm that expands via exports. 7rE(I) and 7rD(I) represent the level of global profits that have been maximized with respect to output and that, therefore, depend only on the level of the firm's R&D invest-

10 M.L. Petit and F. Sanna-Randaccio

MR R&D, *

M C R&D M C R&D = yI

MR R&D, D

MR R&D, E

[E [D I

Fig. 1: The optimum level of R&D expenditure with export and FDI

ment. If we examine now the effect of an increase in R&D expenditures on profits we obtain:

oJrD(I) _ | 0 0I]1] / A) - I (20) ~E(a - + y , OI

OI -- ~ [ ( a - A ) + 0 I ] - - ~ - y I . (21)

It can easily be seen from (20) and (21) that, for any given level of R&D investment I, the marginal effect on profits of an increase in R&D is higher when the firm expands through FDI instead of exports (the positive difference being equal to Os/2b). This is due to the sale-increasing effect of FDI versus export as FDI allows the firm to eliminate transport costs (the parameter s).

If we call the terms in graphs in Eqs. (20) and (21) marginal revenue from R&D (MR R&D' D and MR R&D,E respectively) and y I the marginal cost of R&D (MCR&D), we can see from Fig. 1 that, for any given level of investment in R&D, and thus for any given y I, marginal revenue from R&D is higher when the firm expands through FDI, and therefore the optimal level of R&D investment (which results from marginal revenue being equal to marginal cost) is higher for the MNE.

3.2 The Effect of R&D Investment on the Export-FDI Choice

We shall examine now the effect of R&D activities on the choice of the mode of foreign expansion.


First we must analyze the firm's decision on how to serve the foreign market. The choice of the mode of foreign expansion will obviously depend on the level of optimal global profits corresponding to each of the two possibilities: export or multinational expansion. In other terms a firm will choose to become an MNE if

D _ ~ z > 0 . (22)

This is the sufficient condition for the FDI option to prevail. Now the conditions for FDI with and without research will be com-

pared. To this aim we make a comparison between the results obtained in the case of an international monopolist that makes no research with those of the monopolist that spends in research (that is, with the results of the previous section).

The model that represents the behavior of the monopolist that makes no research and must decide how much to produce and how to expand abroad is a simplified version of the model described in Sect. 2, with the terms containing the variable I (investment in R&D) eliminated from Eq. (1) and from the profit functions (3) and (4). In this case, therefore, unit variable cost and marginal cost are constant and equal to A. The demand functions are the same and Assumptions 2 and 3 still hold.

Case a: Exporting monopoly. Profits are now given by:

7r~R = (a - - b X h ) X h -q- (a -- b X f ) X f - A X h - ( A + s ) X f - G , (23)

where the subscript NR stands for "no research." The maximization of (23) produces the following, well-known, results7:

at'h-- a - A ~ . f _ a - A - s (24) 2b ' 2b '

a + A a + A + s t ) h - - - - , /~f-- , (25)

2 2

_ ~ (a - A) 2 s ( a - A ) s 2 7r~R 2b 2b + ~-~ - G . (26)

7 Note that a necessary and sufficient condition for positive exports is that a - A - s > 0, i.e., that unit transport cost be inferior to the initial demand-cost margin.

12 M. L. Petit and F. Sanna-Randaccio

Case b: Two-plant monopoly. Profits are now given by:

7r~R = (a -- b X h ) X h + (a -- b X f ) X f - - A ( X h + Xf) - 2G , (27)

and we get:

fC~h = f ( f - - a - - A 2b '

a + A = & - - - ,

2

~ . D R _ ( a - A) 2

2b - - - 2 G .

(28)

(29)

(30)

It is now possible to show the following:

Proposi t ion 2: Investment in R&D stimulates the firm to expand abroad via FDI instead of via exports.

Proof." If the monopolist does not invest in R&D, the sufficient condition for choosing to become an MNE instead of an exporter (i.e., ~NDR -- ~NER > 0), from (30) and (26) is given by:

s ~ [ 2 ( a - A) - s] > G . (31)

If on the contrary the monopolist invests in research, the condition ^ D ^ E 7r R - rc R > 0 is given by Eq. (17). Taking the difference between Eqs. (17) and (31) we obtain that:

sO 2 [ 4 ( a - A ) - s ] > 0 . (32)

The sufficient condition for the monopolist to become an MNE is thus less restrictive if the firm invests in research than if it does not. On the one hand, research increases the positive effect of FDI on variable profits, as compared to the case of exports. On the other, FDI implies higher research expenditure than export as it increases the equilibrium level of R&D. Equation (32) shows that, for any values of the parameters that satisfy the second-order condition, the positive effect of research on variable profits more than compensate the increase in R&D expenditure. Therefore, FDI is more likely to occur when the firm spends in R&D.


The positive link that exists between investment in R&D and multinational expansion can also be shown by observing how the difference reD(l) -- rez( I ) varies after a variation in the level of I. We Can see from Eqs. (20) and (21) that:

d[re D(I) -- re E(I)] Os = - - > 0 , (33)

dI 2b

that is, for any given level of investment in research, an increase in R&D expenditure stimulates the firm towards the FDI choice rather than towards exports.

Going back now to Proposition 1, and considering again Proposi- tion 2, we can observe that this link constitutes a two-way relationship. We see in fact that the optimal level of R&D is higher when the firm expands abroad via FDI rather than via exports, since investment in research is stimulated by the profit possibilities generated by multinational expansion (Proposition 1). On the other hand, investment in research increases the probability that the firm will choose to become an MNE (Proposition 2).

This double-way link can be summarized as follows. A monopolist aiming to penetrate foreign markets is autonomously induced to carry out research activities, because R&D investment increases profits both with export and FDI, as will be shown in Sect. 5. However the decision to spend in R&D increases the probability of multinational expansion rather than of exporting [Eq. (32)]. If this is the case, the FDI choice produces a positive feedback effect on R&D expenditure by the firm [Eqs. (6) and (10)], which in turn strengthens the choice of multinational expansion [Eq. (33)].

4 The Role of International Technology-transfer Costs

Let us now examine the case in which the international transfer of technological knowledge is costly. In his seminal contribution, Teece (1977) argued that, when a plant is built abroad, technology-transfer costs are incurred by the investing firm due to pre-engineering technological exchanges, engineering costs associated with transferring the process (product) design, R&D costs associated with problem solving, adapting or modifying the technology, and "excess manufacturing" costs during the start-up phase, s

8 See also Mansfield (1975), Zander (1991, p. 72).


As in Wang and Blomstrom (1992) and in Fung (1994), let us assume that it is more costly to transfer a more complex technology than a less advanced one. Therefore we consider a convex transfer-cost function. Transfer costs are modeled as an increasing function of I , i.e., of the technological level of the firm which depends on the amount of resources devoted to R&D.

Now (4) becomes:

rCTOC = (a - b X h ) X h -+- (a -- b X f ) X f

- (A - OI ) (Xh q- X f ) - y i 2 / 2 - 7112 /2 - 2G , (34)

where the additional term ~ I 2 / 2 captures the costs of international technology transfer, with ~ > 0. 9 Profits for the exporting monopoly remain unchanged, given the assumption that the existing plant presents excess capacity, in other words that in order to serve the foreign market the monopolist does not incur the costs of opening a new plant in the domestic market. 1~

Within this context, if the firm goes multinational the equilibrium level of R&D becomes

^ O ( a - A )

[ D = b y + btl - 0 2 ' (35)

where b y + b t / - 02 > 0 for the second-order condition. 11 Taking the difference between (35) and (10) we obtain:

i D c _ i E = O [ s ( b y - 02) - b0(2(a - A) - s)] (36) 2 ( b y - 02 ) (by -k- b r / - 02)

9 The imperfect transferability of technology may also be modeled as a lower value of 0 for the subsidiary (i.e., Of < Oh). This way of modeling the problems involved in the international transfer of technology leads to the same results obtained when using quadratic transfer costs.

10 If the exporter had to build a new domestic plant, export would also be characterized by technology-transfer costs. In fact what does really matter is the transfer of technology from one plant to the other, and not the fact that the transfer takes place across borders. Teece (1977) finds that the "international component" of the transfer cost may be negative, in the sense that there are cases in which it is less costly to transfer the technology internationally than in the home market.

11 The introduction of transfer costs for the FDI case leaves unchanged the marginal revenue from R&D schedule in Fig. 1. The MC Re~D schedule rotates anticlockwise, as now the marginal cost of R&D is given by (y + t/)l.


For Proposition 1 to hold, the difference between the R&D equilibrium levels should be positive [i.e., Eq. (36) > 0]. This condition will be satisfied only if the term in brackets is greater than zero.

We may thus observe that, in presence of technology-transfer costs, we cannot say with certainty that the choice of becoming MNE will result in a higher equilibrium level of R&D investment. That will depend on parameter values. In particular, Eq. (36) shows that, as compared to export, multinational expansion is more likely to promote R&D investment the lower the transfer costs (i.e., 7); the higher the transport costs (i.e., s), the less innovative is the firm/sector examined. 12 This last result is a direct consequence of the hypothesis that transfer costs are increasing in the amount of technology transferred. The lower are A and y and the higher is 0, the greater the amount of R&D undertaken by the parent company and thus, given the hypothesis of quadratic costs, the higher the unit cost of technology transfer. If the costs of technology transfer are modeled as a linear function of I (see Appendix B.2), the condition for Proposition 1 to hold is on the contrary less stringent the more innovative is the firm/sector considered. All other results are instead confirmed. Thus whether MNE expansion is more likely to stimulate R&D activities in the case of a more technology-intensive or of a less technology-intensive firm/sector rests on the empirical fact of how transfer costs rise with the complexity of the knowledge transferred to the subsidiary.

We define 77 .1 as the value of the transfer-cost parameter for which Eq. (36) is equal to zero. Then:

11 *l -= s ( b F - - 02) (37) b(2(a - A) - s)

Thus for ~7 </7 .1 Proposition 1 is still valid, i.e., notwithstanding the imperfections in the international transfer of technology it is still true that MNE expansion stimulates R&D investment. The case of r/ < ~7 *1 will be labeled as the low-transfer-cost scenario.

12 As to the last point, we find that the term in brackets in Eq. (36) is a positive function of A, the parameter which is inversely related with the firm's initial technological competence, of y which is inversely related to the firm's cost effectiveness in R&D, while it is negatively related to 0, which shows the productivity of the firm's research effort. Note that 2/ and 0 may be considered firm- or sector-specific parameters.


The equilibrium profit in the case of FDI then becomes:

(y + / 7 ) ( a - A ) 2 _ 2 G ( 3 8 ) frTOC = 2 ( b y + b/7 - 02) '

and the difference between the conditions for choosing FDI in the case of research (see Appendix B.1) and in that of no research [Eq. (31)] is n o w . :

- -

0 2 [ s ( 4 ( a - A ) - s)(bF - 02) - b/7(4(a A ) ( a - A - s ) + s2)]

8b(bF - 02)(bF + b/7 - - 0 2)

(39)

If the term in brackets in Eq. (39) is positive, Proposition 2 is valid also with imperfect technology transferability. As expected, we find that R&D is more likely to stimulate the firm to go multinational the lower the transfer-cost parameter/7.

We define/7.2 as the value of the transfer-cost parameter for which Eq. (39) is equal to zero:

/7,2 = s(4(a - A) - s)(bF - 02) (40) b(4(a - A ) ( a - A - s ) + S 2) "

Thus for /7 < /7,2 Proposition 2 is valid, i.e., notwithstanding the imperfections in the international transfer of technology, it is still true that research activity stimulates multinational expansion. We may observe that since /7.2 > /7.1, the condition for Proposition 2 to hold is less restrictive than that for Proposition 1. In other words if the international transfer of technology is costly it is more likely that investment in research will stimulate the firm to go MNE rather than that the FDI choice will have a positive effect on R&D expenditure.

To sum up, in the case of low transfer costs (i.e., /7 < /7"~), both Proposition 1 and 2 are valid and the two-way link still prevails. How- ever, for higher values of/7 it may be the case that Proposition 2 is valid while Proposition 1 is not, or that both are violated.

In the following sections, as we focus on developed countries, we will revert to the hypothesis of/7 = 0, as a limit case of the low-transfer- cost scenario. This assumption may be justified on the following basis. Several authors have suggested that the level of development of the host country and the similarity between host and home country are important


determinants of the level of costs in an international transfer of technology from parent company to foreign subsidiary (Mansfield, 1975; Teece, 1977). The greater the similarity between the two markets, and the higher the level of development of the recipient country, the lower the costs of adaptation which are a considerable part of total transfer costs. Furthermore when the subsidiary is located in another developed country it is less likely that there will be "excess manufacturing costs" in the start-up phases. These are the reasons why the transfer-cost is- sue is a problem generally dealt with in a North-South context (as in Wang and Blomstrom, 1992; Fung, 1994), while studies focusing on FDI among developed countries generally assume that the mother company transfers costlessly its knowledge to the foreign affiliate (as in De Bondt et al., 1988; Veugelers and Vanden Houte, 1990).

5 Welfare Effects o f R&D Inves tment and of the M o d e of Fore ign Expans ion

Let us analyze the effects of R&D activities on consumer and producer welfare.

By comparing Eq. (25) with Eqs. (13) and (14) we obtain Ê P i , R <

,b E , since: i,NR

Ê Ê 0212(a -- A) - s] Pi ,R -- P i ,NR = 4 ( b y - - 02) < 0, i = h, f . (41)

We recall that 0 > 0, b y - 02 > 0 for the second-order condition (Sect. 3) and 2 ( a - A ) - s > 0 for the condition for export to be positive (see footnote 7).

Taking now the difference between Eqs. (15) and (26) we obtain

0 2

~ E _ ~ E R __ 8 b ( b y - - 0 2 ) [ 4 ( a - A ) ( a - A - s ) + s 2] > 0 , (42)

where a - A - s > 0 (see again footnote 7). ^D *bD since A comparison of Eqs. (29) and (8) shows that Pi ,R < i,NR

^D _ *bD 02(a -- A) Pi,R i,NR - - 2(b~ / - 02) < 0, i = h, f . (43)

Note that a - A > 0 by Assumption 3. As for profits, a comparison


of Eqs. (30) and (9) shows that 7~ > ~ R since:

02(a - A) 2 ~D _ ~ D -- 2--~-Y - ~ - ~ ) > 0 . (44)

We can now state the following propositions.

Proposition 3: Technological innovation is beneficial for both consumers and producers.

For a proof, see Eqs. (41)-(44).

Both the MNE and the exporting firm produce at lower (unit) costs and obtain higher profits when they carry out research activities. There is therefore a private incentive for the monopolistic finn to spend in research, which turns out to be beneficial also for the consumers since the monopolist sells at lower prices both in the home and foreign country.

It is interesting to notice that the increase in profits is higher for the MNE than for the exporting firm. And also that the price decrease is larger (in absolute value) in both countries when the firm is an MNE rather than an exporter. The reason is that, as we have seen in the previous section, an MNE spends more in R&D and can thus produce at lower costs and sell at lower prices. This means that the monopolist does not appropriate all the benefit that derives from the higher cost decrease (due to the higher level of research) and that a part of this benefit goes to the consumers.

Proposition 4: Technological innovation increases the economic inter- dependence between countries.

Proof." Consider the change in the foreign-country market structure, which takes place when the nonresident monopolist shifts from export to FDI. When there are no R&D activities, such a change has no repercussions on the home-country price, as we can see from Eqs. (25) and (29). Consumer surplus in the home country will thus be unaffected. On the contrary, when the firm spends in R&D, the fact that the foreign country is served via FDI instead of export has repercussions on the home-country price: Ph too falls, as shown by a comparison of Eqs. (8) and (13). Thus, when there are R&D activities, a change in market structure in the foreign country has a greater impact on the home-country welfare than with no research, since consumer surplus


will increase and the home-firm profit will rise by more than in the no-research case, as shown by Eq. (32). []

Therefore, our results show that changes occurring in one country have feedback effects on the other country and repercussions on welfare that will not take place if the firm does not spend in R&D.

Proposition 5: Consumer welfare is higher in both countries if the firm is an MNE instead of an exporter, when the firm invests in R&D.

This can be seen by comparing Eqs. (8) and (13)-(14). The higher production induced by the higher level of R&D expenditures results in lower prices in both countries when the firm expands via FDI. Tradi- tional models not taking into account R&D would suggest that a firm that expands abroad via FDI would apply at home the same prices as an exporter, but lower prices abroad, due to the elimination of transport costs s [see Eqs. (25) and (29)]. The introduction of R&D expenditures into the model alters this conclusion since, as we have seen, an MNE spends more in research, and therefore can reduce prices both abroad and in the home country.

6 Export and FDI Regions under Alternative Technological Scenarios

In this section we shall examine how variations in some key parameters may alter the configuration of the international market. In fact, whether export or FDI will prevail, i.e., whether Eq. (17) is satisfied, depends on the values of the two demand parameters (a, b) and of the five technology parameters (A, 0, y, s, G). The focus of the analysis is on the direction of the movements of the boundary between the export and FDI regions.

In Fig. 2a-d the possible equilibrium modes of foreign expansion are illustrated by considering the (y, s) plane. The two parameters have been chosen to show the interaction of the location and R&D decisions. While s (transport cost) can be considered as a key location parameter as it affects the export-FDI choice also in the no-research case, y (inversely related to the firm's R&D-cost effectiveness) is a key factor in the R&D choice (i.e., affects this choice also if we do not contemplate the international setting). In the subsequent analysis the following values of the parameters have been considered: a = 36, b = 2, A = 5, 0 = 0.3, G = 15. All values are such that Assumptions 1-3 (see

2.00

1.95

1.90

1.85

1.80

fg

. di

rect

inve

stmen

t

1.75

,

......

...

d

0.4

0.6

0.8

1.0

1.2

1.4

1.6

1.8

2.0

2.2

g

NC

*

2.00

fg

. dire

ct in

vestm

ent

1.95

/

~-

--

1.90

1.85

1.80

1.75

0.4

0.6

0'.8

110

112

114

116

1.8

2.0

2.2

Y

NC

with

0

= 0.

2 N

C*

with

0

=0

.3

2.05

2.00

1.95

1.90

1.85

1.80

1.75

0.4

0.6

0.8

1.0

1.2

1.4

1.6

1.8

2.0

2.2

Y

NC

with

A

=6

NC

* w

ith

A=

5

2.70

2.

60

2.50

2.

40

2.30

2.

20

2.10

2,

00

1.90

1.

80

fg. d

irect

inve

stm

ent

//~

expo

rt

NC

with

G

=2

0

NC

* w

ith

G=

15

1.70

0.4

016

0'.8

1'.0

1.2

1'

.4 1

'.6 1

.8 2

.0 2

.2

Y

to

O


Sect. 2) and the second-order conditions are verified. The parameters y and s are allowed to vary within the ranges indicated on the axis of the corresponding figures. Computations have been performed for a wide range of values of all the parameters, which did not alter the direction of the frontiers' shifts.

The boundary between the export and the FDI regions is defined by the values of y and s which satisfy condition (22) as equality. We can define the condition z? D_~ E = 0 as the export-FDI neutrality condition (NC). The NC schedule in Fig. 2a is thus the locus of all combinations of y and s which ensure that the monopolist is indifferent between export and FDI. As y rises the equilibrium level of R&D falls and such a fall is more pronounced in the case of FDI than in that of export [compare Eqs. (6) and (10)]. Thus, the difference between the marginal cost of FDI and of export becomes smaller, consequently the left-hand side of (17) decreases. For the neutrality condition to hold, a rise of V must be associated to an increase of s. A higher value of s leads to a rise in the additional variable profits from FDI as compared to export [left-hand side of (17)] for two reasons. First, for any given level of research, higher transport costs imply an increase in the difference between the marginal cost of export and of FDI. Second, higher values of s lead to an increase in the gap between the optimum level of R&D with and without foreign production [i.e., raise the difference between (6) and (10)]. Thus the NC schedule is upward sloping. Fig. 2a also shows that when the firm becomes less R&D-cost effective (i.e., V rises) the FDI region shrinks as higher values of s are necessary for the firm to choose to produce abroad.

Figure 2b shows that the NC schedule shifts upward when A rises. The parameter A is the initial marginal cost and can be considered as inversely related to the firm's technological competence. The greater the technological competence of the firm (i.e., the lower A) the more likely that the firm will invest abroad (i.e., the FDI area is larger when A is lower). This result gives support to the hypothesis suggested by the product-life-cycle model that technological leaders are more likely to lead international expansion.

Figure 2c shows how the export and FDI regions change with a change in 0 (the firm R&D productivity). When 0 is smaller the NC

Fig. 2: Export and FDI regions defined by the neutrality condition, a, the NC schedule; b, the NC schedule with changes in the initial marginal cost; c, the NC schedule with changes in the firm R&D productivity; d, the NC schedule with changes in the fixed plant cost. * traced for a = 36, b = 2, A = 5,

0 =0.3, G = 15


curve shifts upward as in the case of a fall in the firm technological competence. We may note that a decrease in 0 leads to a greater con- traction of the FDI area when the values of g are low and thus in association with high R&D equilibrium levels.

Figure 2d shows that with a rise in the fixed plant cost (G) the FDI area - as one could expect - shrinks, i.e., the NC schedule shifts upwards. When G rises, in order for FDI to take place the additional variable profits from foreign production must increase, and thus, for any given value of V, s must rise.

7 Conclusion

We have developed a two-country model of international expansion, where a monopolist carrying out research activities can choose between expanding abroad via foreign direct investments or via exports. The use of linear functional forms has allowed us to obtain analytical results, that would have been impossible with a more complex model.

An interesting result of our analysis is that, with low costs of technology transfer, 13 there is a two-way relationship between R&D and multinational expansion by the firm, since the presence of R&D activities makes the FDI choice more likely, and the FDI choice produces a higher level of R&D.

On the one hand, we find a positive relationship between multinational expansion and R&D activities, the optimal level of R&D expenditure of an MNE being higher than that of a firm which exports its home production. This result seems to confirm the existing empirical investigations which show that multinational companies are more innovation-oriented than domestic (one-plant) firms.

Since there is also a positive (negative) link between R&D investment and the level of sales (prices), it follows that consumer welfare is higher in both countries when the firm makes the FDI rather than the exporting choice.

On the other hand, by making a comparison between the decisions of a firm that does not spend in research and those of a firm that carries out research activities, we have shown that technological innovation through R&D increases the probability that the firm chooses multinational expansion rather than export, since it renders the condition for the FDI choice less restrictive than the corresponding condition for a firm that makes no research. We have also found that technological innovation through R&D is beneficial for both consumers and

13 For a definition see Sect. 4.


producers. Therefore, firms pursuing a profit-maximizing objective are induced to spend in research, and this expenditure has a positive effect on consumers' rent.

To summarize: profit maximization pushes the firm towards research activities and these activities increase the probability of multinational expansion, which in turn increase R&D expenditures by the firm. Both the research choice and the FDI choice have a positive effect on consumers' welfare in both countries.

The interaction of the location and R&D decisions have been examined by defining the export and FDI regions under alternative technological scenarios. The results show that the greater the initial technological competence, R&D productivity, and R&D-cost effectiveness of the firm, the more likely it will invest abroad. These findings give support to the hypothesis suggested by the product-life-cycle model that technological leaders are more likely to lead international expansion.

Appendix

A Proof of Inequality (16), Sect. 3

From the maximization of the profit function (3) of the exporting firm we obtain, from first-order conditions,

a - A + O I - s Xf = (A1)

2b

Therefore, a condition for positive exports (Xf > 0) is that

a - A + 0 I - s > 0 . (A2)

But since the optimal value of i is given by Eq. (10), (A2) becomes

by(a - A) > �89 - 0 2) . (A3)

Dividing both sides by 2b and multiplying by s we get

s 2 g--~-~ (a - A) > -77-,(2by - 0 2) (A4) i

4/9


I f (A4) holds, the fo l lowing inequali ty must also hold

y S S 2

- T (a - A) > 8-~ (2b V - 0 2) . [] (A5)

B.1 Quadra t i c Costs o f In t e rna t iona l Technology Trans fer

Fr D R,TC - - j~E

L ( 2 b g s ( 2 ( a - A ) - s) -t- s a o e ) ( b ? " + brl - o2)J - 4brl(a - A)e0 2

8 b ( b g - 0 2 ) ( b y + b~l - 02)

( B 1 )

B.2 L i n e a r Costs o f In t e rna t iona l Technology Trans fer

I f the costs o f international technology transfer are mode led as a l inear funct ion of I , in part icular as k I with k > 0, we have:

rCTDc = (a -- b X h ) X h q- (a -- b X f ) X f (B2)

- (A - O I ) ( X h + Xf) -- y i 2 / 2 - k I - 2 G ,

[TDc = 0 ( a -- A ) - b k b y - 02 ' (B3)

i D _ i E _ O s - Z b k 2 ( b v - 0 z) ' (B4)

} , ( a - A) 2

(Vy (BS) -- k L(bg - 02)(O(a -- A ) - b k ) + b y O k ( a - A)J _ 2 G ,

2 ( b y - 02)

^ D ~rRE ) _ (~DR _ ~.NER) = sO214(a -- A ) -- s] (TrR'TC - - 8 b ( b y - - 0 2)

(B6) 4bkL(O(a - A ) - b k ) ( b g - 02) + b g O k ( a - A)J

8b(b V - 02)


Acknowledgements

We wish to thank John Cantwell and two anonymous referees for valuable suggestions. Financial support from Consiglio Nazionale delle Ricerche is gratefully acknowledged.

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technological innovation and multinational expansion: a two-way link?

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