Centre for International Economic Studies
Policy Discussion Paper
No. 0022
University of Adelaide • Adelaide • SA 5005 • Australia

Keith E. Maskus
Professor of Economics
University of Colorado, Boulder, USA
Phone: (303) 492-7588
Email: Keith.Maskus@colorado.edu

May 2000

This paper reviews the theory and evidence on how intellectual property rights may influence decisions on FDI and technology transfers. The message is that, while there are indications that strengthening IPRs can be an effective incentive for inward FDI, it is only a component of a broader set of factors. Policy makers should recognize the complementarities among IPRs, market liberalization and deregulation, technology development policies, and competition regimes. These are complex issues, leading to complicated tradeoffs for market participants. Governments may wish to devote considerable attention and analysis to devising means for assuring their countries will achieve net gains from stronger IPRs and additional IPRs and licensing over time.

The global system of intellectual property rights (IPRs) is changing profoundly. Many developing countries have undertaken significant strengthening of their IPRs regimes. Several regional trading arrangements now address questions of regulatory convergence, particularly in IPRs. Most significant is the introduction of the agreement on trade-related intellectual property rights, or TRIPs, within the World Trade Organization (WTO). Under TRIPs, WTO members must adopt and enforce strong and non-discriminatory minimum standards of protection for intellectual property. Many developed countries are extending strong protection to controversial areas, including biotechnology and electronic databases.

The movement toward much stronger global IPRs is consistent with processes of economic globalization, or the successively closer integration of national and regional markets through the reduction of barriers to trade, investment, and technology flows. In this world, knowledge creation and its adaptation to product designs and production techniques are increasingly essential for competitiveness and growth. This situation takes on political importance because the international mobility of capital and technology have risen markedly relative to that of most types of labor. In turn, globalization pays its largest rewards to creative and skilled workers and places its largest pressures on lower-skilled workers.

The means by which IPRs influence FDI are complex and subtle. Furthermore, strong IPRs alone are not sufficient incentives for firms to invest in a country. If they were, recent FDI flows to developing economies would have gone mainly to sub-Saharan Africa and Eastern Europe. In contrast, China, Brazil, and other high-growth, large-market developing economies with weak protection would not have attracted nearly as much FDI. And as noted above, IPRs are an important component of the regulatory system, including taxes, investment regulations, production incentives, trade policies, and competition rules. Thus, from a policy perspective, it is the existence of a pro-competitive business environment that matters overall for FDI.

This analysis points out that, in theory, investment and technology transfer do not necessarily expand with stronger intellectual property rights, but there is emerging evidence in favor of that view. It is increasingly assumed around the globe that FDI and licensing are beneficial for the recipient country and there is a strong presumption in this direction but it is not a necessary outcome in all situations. Rather, it is important that such flows result in stronger competition on local markets, which tends to promote long-run gains.

In terms of policy options, freer market access, together with sensible competition rules and related regulatory systems, promise to promote the greatest net benefits from incoming investment. Thus, economies that wish to increase their attractiveness to foreign investors would be advised first to undertake significant market liberalization. While the Uruguay Round committed most countries to cutting trade barriers, further reduction of tariffs and removal of NTBs on a credible schedule would provide an important signal to foreign investors. Regional trade integration, particularly with developed economies that could be the source of additional FDI, could assist in this process. However, such agreements also bear potential for trade and investment diversion and should be considered carefully in each instance.

The global system of intellectual property rights (IPRs) is changing profoundly. Many developing countries have undertaken significant strengthening of their IPRs regimes. Several regional trading arrangements now address questions of regulatory convergence, particularly in IPRs. Most significant is the introduction of the agreement on trade-related intellectual property rights, or TRIPs, within the World Trade Organization (WTO). Under TRIPs, WTO members must adopt and enforce strong and non-discriminatory minimum standards of protection for intellectual property. Many developed countries are extending strong protection to controversial areas, including biotechnology and electronic databases.

The movement toward much stronger global IPRs is consistent with processes of economic globalization, or the successively closer integration of national and regional markets through the reduction of barriers to trade, investment, and technology flows. In this world, knowledge creation and its adaptation to product designs and production techniques are increasingly essential for competitiveness and growth. This situation takes on political importance because the international mobility of capital and technology have risen markedly relative to that of most types of labor. In turn, globalization pays its largest rewards to creative and skilled workers and places its largest pressures on lower-skilled workers.

Markets are becoming more integrated through changes in both natural forces and government policies. The former group consists of falling transport costs, improving global communications, and massively increasing computing power. The latter group includes trade liberalization, deregulation of investment and licensing restrictions, provision of establishment rights in services, privatization of state-owned enterprises, adoption of freely-traded currencies, and tax reform. The central feature of policy making in many emerging economies in the 1990s has been a sharp movement toward improving market access, through both unilateral policy reform and adherence to regional and multilateral trade agreements.

The channels through which globalization affects economies include trade, portfolio investment and foreign direct investment (FDI), and product and technology licensing. Foreign direct investment is particularly important because it is both a source of capital and a provider of knowledge about production techniques.

The direct impact of globalization is stronger arbitrage of international prices of goods and tradable services and greater access by consumers and firms in each liberalizing country to new and more varied products and technologies on international markets. In turn, such economies experience increases in competition, reductions in domestic market power of formerly concentrated industrial concerns, re-allocations of economic resources into areas of comparative advantage, falling production costs in sectors with increasing returns to scale, and contraction or elimination of uncompetitive firms. Over the long term, competitive pressures encourage adoption of advanced technologies and development of high-quality, differentiated products for both domestic production and export. The stronger markets encouraged by liberalization could lead to a permanently higher growth rate.

There is considerable evidence to support this optimistic view of globalization. However, there are potential costs. Greater competition changes demands for labor in each country, with unskilled workers bearing the brunt of competitive pressures. Also of concern are potential abuses of market power to the extent that larger international firms are placed into a position of market dominance by virtue of their marketing advantages or technological superiority.

This brief review suggests that developing countries have rising interests in attracting FDI and technology. However, policies to promote such activities must be accompanied by programs to build local skills and ensure that the benefits of competition emerge. Intellectual property rights are an important element in a broader policy package that governments in developing economies could pursue with a view toward promoting dynamic competition in which local firms participate significantly. This broad "cocktail" of policies would include promoting political stability, encouraging flexible labor markets and building labor skills, continuing to liberalize markets, and developing forward-looking regulatory regimes in services, investment, intellectual property, and competition policy.

It is beyond the scope of this paper to consider each of these issues and their complex interrelationships. Instead I consider the issue of how IPRs influence FDI and technology inflows, which is the subject of Section Two. I then overview, in Section Three, the available economic evidence about IPRs as a determinant of FDI. In Section Four I discuss the potential benefits and costs of incoming FDI and technology transfer, emphasizing information spillovers and diffusion. Throughout, the impact of IPRs is considered. I also present the broad outlines of a pro-competitive strategy for attracting investment and technology. Inevitably, such strategies vary across countries by level of economic development and technological capability but there are important common denominators. In a final section I discuss outstanding research issues and provide concluding remarks.

The means by which IPRs influence FDI are complex and subtle. Furthermore, strong IPRs alone are not sufficient incentives for firms to invest in a country. If they were, recent FDI flows to developing economies would have gone mainly to sub-Saharan Africa and Eastern Europe. In contrast, China, Brazil, and other high-growth, large-market developing economies with weak protection would not have attracted nearly as much FDI. And as noted above, IPRs are an important component of the regulatory system, including taxes, investment regulations, production incentives, trade policies, and competition rules. Thus, from a policy perspective, it is the existence of a pro-competitive business environment that matters overall for FDI.

Nonetheless, it is useful first to discuss how the strength of IPRs could affect FDI decisions. Ultimately, what matters to the firm is the likelihood that an investment will raise its expected profits. While there are numerous factors that influence profitability, the issue regarding IPRs is the extent to which the regime affects the firm’s perception that it will be able to earn a higher return on its protected knowledge-based assets (KBAs) through FDI, relative to other means of earning such returns.

This complex subject allows few clear conclusions. A firm with a KBA has numerous options in servicing a particular foreign market. It could export the good through standard channels. It could produce locally within the firm through FDI, thereby directly controlling the production process. It could license or franchise its asset to an unrelated firm and allow local production in return for royalties and fees. Finally, it could enter into a joint venture involving some common production or technology-sharing agreement. These decisions are jointly determined and more than one mode of supply could emerge.

Trade is likely to be the primary channel where transport costs and tariffs are low in relation to FDI and licensing costs. The relationship between export volume and the strength of local IPRs has been analysed by Maskus and Penubarti (1995). Strong IPRs in all forms -- patents, trademarks, copyrights, and trade secrets -- provide protection for exporting firms against local imitation, thereby increasing the market size facing exporters and inducing them to expand sales. This "market-expansion effect" is likely to be important in countries with large markets and established technical capabilities for imitating products and technologies. However, IPRs permit such firms additional market power, although concerns about the competitive implications of this "monopoly effect" are often exaggerated (Maskus and Eby-Konan, 1994). It is more likely to prevail in countries with small markets and limited imitative abilities. Empirical evidence shows that, other things equal, countries with stronger IPRs do attract more imports, though the effect varies across industries (Maskus and Penubarti, 1995). Stronger trademarks seem particularly significant in increasing imports of clothing and other consumer goods because the low costs of knocking off such products under weak trademarks limits interest of foreign firms in offering them for export. In effect, stronger trademarks reduce exporting costs because a firm is less compelled to discipline local imitators through lower prices. This phenomenon holds also in pharmaceuticals, though they are more likely to be produced under local license than imported. Export volumes in goods that are difficult to imitate, such as certain kinds of machinery, or are less dependent on trademarks, such as basic metal manufactures, are less sensitive to IPRs. These results have been refined by Smith (1998), who reached similar conclusions.

Foreign direct investment is likely to displace exports where there are high trade and transport costs,¹ low fixed costs of erecting plants, high productivity relative to labor costs, large host market size, and substantial R&D and marketing intensities of the products in question. The last factor, reflecting the intellectual component of the firm’s advantage, is an important determinant of horizontal FDI in differentiated goods and advanced technologies.

According to this analysis, IPRs should have variable degrees of importance in different sectors in terms of encouraging FDI. Investment in lower-technology goods and services, such as textiles and apparel, electronic assembly, distribution, and hotels, depends far less on the strength of IPRs than on input costs and market opportunities. Firms investing in a product or technology that is costly to imitate may also place little emphasis on local IPRs in location decisions, though falling imitation costs in many sectors raise the importance of IPRs. Firms with easily copyable products and technologies, such as pharmaceuticals, chemicals, food additives, and software, are more concerned with the ability of the local IPRs system to deter imitation. Firms considering where to invest in a local R&D facility would pay particular attention to protection for patents and trade secrets.

The evidence reported in Mansfield (1994) is consistent with these observations. In a survey of 100 major U.S. firms representing six industries, intellectual-property executives were asked their opinions of the importance of IPRs in their FDI and licensing decisions and their assessments of the adequacy of IPRs in 16 countries. Table 1 shows the survey responses regarding type of investment facility. There is little concern in any industry about IPRs protecting the operation of sales and distribution outlets. In the chemical industry, which includes pharmaceuticals, 46% of firms are concerned about protection for basic production and assembly facilities, 71% for components manufacture, 87% for complete products manufacture, and 100% for R&D facilities. This tendency to be more concerned with IPRs, the higher the stage of production, holds in all sectors. Overall, chemicals firms are most influenced in their investment decisions, while in all sectors strong concerns exist about local IPRs in locating R&D operations. In a related analysis, Mansfield (1995) shows that these conclusions hold also for Japanese and German MNEs.

Source: Mansfield (1994)

Source: Mansfield (1994). Note: ^a Average over the seven countries listed.

Table 2 presents further results for selected countries with weak IPRs. India elicits the greatest concern about IPRs, with 80% of the chemical firms surveyed indicating that they would not engage in joint ventures or transfer new technologies to subsidiaries or unrelated firms due to weak protection. There is little difference between joint ventures and subsidiaries in this regard. Both activities evidently afford chemical firms with similar levels of security about their technologies (though there is more concern about joint ventures in Mexico and Indonesia). However, across all countries licensing to unrelated firms is seen as riskier than joint ventures. This situation seems also to characterise machinery. In the other sectors, however, there is little difference in the willingness to transfer technology through various modes according to weakness in intellectual property rights.

Thus, licensing is perceived to be insecure relative to investment in the high-technology sectors in countries with weak IPRs. This fact illustrates a subtle aspect of intellectual property protection. Firms prefer FDI to licensing when they have a complex technology and highly differentiated products and when there are high costs of transferring technology through licensing (Teece, 1986; Davidson and McFetridge, 1984, 1985; Horstmann and Markusen, 1986). In these situations it is efficient to internalize the costs of technology transfer through FDI in a majority-owned subsidiary. As IPRs improve, licensing costs should fall because it becomes easier to discipline licensees against revelation or appropriation of proprietary technology and against misuse of a trademark. Thus, for a given level of complexity of innovations, we would expect to see licensing supplant FDI as IPRs are strengthened.

A summary of the predictions about IPRs, FDI, and technology transfer is in order. First, investment and technology transfer are relatively insensitive to IPRs in industries with standardized, labor-intensive technologies and products. Second, FDI representing complex but easily copied technologies is likely to increase as IPRs are strengthened because such rights enhance the value of KBAs, allowing efficient exploitation through internal organization structures. Third, to the degree that stronger IPRs reduce licensing costs, FDI could be displaced by licensing. Finally, whatever the channel, the quality of technologies transferred rises with the strength of IPRs.

An implication of this logic is that rapidly growing developing countries should develop a natural interest in improving their IPRs regime over time as they move up the "technology ladder" to an ability to absorb and even develop more sophisticated innovations. This is perhaps the strongest argument to make in favor of adopting stronger protection in nations such as Korea, Brazil, and Malaysia. In the early stages of their industrial growth, such countries have an interest in being able to imitate imported technologies. As they develop, however, they become increasingly willing to tighten IPRs, both in order to attract the most modern technologies and to encourage local innovation. This prediction is consistent with the international pattern of patent protection (Maskus and Penubarti, 1995).

Nevertheless, the implications of stronger IPRs for technology transfer are ambiguous in principle. Technological information is diffused across firms or countries through several channels. Regarding patents, on the one hand they facilitate information transfer (if not the spread of know-how) by revealing the details of inventions in published application. This information then may be used by rival firms to develop follow-on products that do not violate the patent scope. As more countries award and enforce patents, there should be additional global innovation and patenting, with a positive impact on follower innovation. On the other hand, patents could reduce technology diffusion by permitting restrictive licensing arrangements for critical technologies. This has long been the view of patents in many developing nations.

Recent theoretical analyses of the effects of patents on technology diffusion in growth models contain mixed messages. In some models, technology is transferred through imitation by firms in technology importers. When the international IPRs system adopts stronger minimum standards, imitation becomes harder as foreign patents are enforced. The rate of imitation declines, which ultimately reduces the global rate of innovation as well because as innovative firms expect slower loss of their technological advantages they earn higher profits per innovation, reducing the need to engage in R&D (Helpman, 1993; Glass and Saggi, 1995).

This result is sensitive to model assumptions. Indeed, Lai (1998) finds that product innovation and technology diffusion are expanded under stronger property rights if technology is transferred through FDI rather than imitation. This finding points up the advantages for developing economies of liberalising restrictions against inward FDI as they strengthen their IPRs. Yang and Maskus (1998) demonstrate that because IPRs reduce contracting costs (associated with information asymmetries), licensing activity and innovation could expand with stronger protection. Vishwasrao (1994) shows in that, while the mode of technology transfer is affected by IPRs protection, with internalization through FDI the preferred solution in countries with weak patents, the quality of technologies transferred rises with stronger IPRs. Taylor (1994) also shows that technology transfer expands with stronger patents when there is competition between a foreign innovator and a domestic innovator. A failure to provide patents removes the incentive for the foreign firm to license its best-practice technologies. Rockett (1990) finds that in cases where local imitation focuses on licensed technology, foreign licensors make available lower-quality technologies. This reduces the licensee’s incentive to imitate, limiting both the quality and extent of knowledge transfer.

Studies of international patenting behavior (Eaton and Kortum, 1996) indicate that the value of patent rights varies across countries and technology fields, but is typically significant in important developing countries, suggesting that stronger patents would encourage further R&D, patent applications, and patent working. There are considerable spillovers of technological knowledge through patenting and trade in patented products. Indeed, Eaton and Kortum claim that OECD countries have derived substantial productivity growth from importing knowledge through patent applications, with U.S. applications serving as the driving force.

The transfer of technology through trade in technical inputs (machinery, chemicals, software, producer services, and so on) is also important. Evidence suggests that such trade accounts for significant productivity gains across borders and is part of the technology convergence among developed economies (Coe and Helpman, 1995). This suggests that emerging economies have a joint interest in trade liberalization and linking their IPRs systems with those of the developed countries. Resulting productivity gains could outweigh costs associated with market power.

A final comment about the emerging system of global IPRs is in order. To the degree that different levels of IPRs across countries are a locational determinant of FDI and technology transfer, the trend toward harmonization of IPRs could offset such advantages. Thus, it would make more attractive those countries that strengthen their IPRs but would reduce the relative attractiveness of countries already providing strong IPRs. This harmonization of global minimum standards presents great opportunities for firms that develop technologies and products because they will no longer have to pay as much attention to localized protection and enforcement problems. Rather, they can focus their R&D programs on those areas with the highest global payoffs. Ultimately, however, it means that IPRs no longer will play much role in determining locational choice.

The discussion so far has presented a narrow interpretation of how IPRs interact with incentives for FDI and technology transfer. However, it could be that effective IPRs play a larger role in signaling to potential investors that a particular country recognizes the rights of foreign firms to make strategic business decisions without government interference (Sherwood, 1990). In this view, trade liberalization is insufficient to provide assurances that an economy is becoming more open to international commerce. Market access could remain blocked by inefficient investment regulations, limited rights of establishment, controls on credit, production, and marketing, arbitrary taxes, licensing restrictions, and weak IPRs. The need to attain market access through rationalization of these internal barriers is now at the top of the international trade-policy agenda (Hoekman, 1997). Some observers also consider IPRs to convey a commitment to move from opaque to transparent legal systems and from corruption to professionalism in public management.

As IPRs take on increasing importance to MNEs, the adoption of stronger regimes has become a primary signal that governments are moving toward a more business-friendly environment. The objective is to attract more FDI through this signal, whatever the incentives that may be generated in various industries by stronger IPRs. There is little evidence to date suggesting that FDI is responsive to this signal, but belief in its importance is growing in developing economies. This phenomenon explains why many poor countries have strengthened their IPRs laws and enforcement despite serious questions about the wisdom of doing so. They fear being left behind in the global competition for capital and technology.

It is apparent that IPRs could play an important role in FDI decisions. However, they have rarely been incorporated into empirical work on the determinants of investment, largely because of the inherent difficulty of measuring IPRs and their impacts. However, a few economists recently have examined the strength of IPRs in different countries as a potential determinant of FDI.

Three early studies (Ferrantino, 1993; Mansfield, 1993; Maskus and Eby-Konan, 1994) found no relationship between crude measures of intellectual property protection and international FDI by U.S. multinational enterprises. However, their models were limited in specification and plagued by poor measurement, and their results should be discounted.

Two recent studies are worth discussing. Lee and Mansfield (1996) surveyed American MNEs to develop an index of perceived weakness of IPRs in destination countries. They regressed the volume of U.S. direct investment in various countries over the period 1990-1992 on this index, along with measures of market size, the past investment stock, the degree of industrialization, a measure of openness, and a dummy variable for Mexico. In their work, weakness of IPRs was found to have a significant negative impact on the location of American FDI. Further, among MNEs in the chemical industry the percentage of FDI devoted to final production or R&D facilities was negatively and significantly associated with weakness of protection. The weakness of IPRs had less impact on the decisions of firms with minority ownership of local affiliates because such firms would be unlikely to transfer their most advanced technologies in any case. Thus, it appears that both the quantity and technological sophistication of FDI are reduced in countries with limited IPRs.

Maskus (1998) argued that analysts must recognise the joint decisions made by MNEs. Firms may choose to export, increase sales from foreign operations, raise investment, or transfer technology directly in response to stronger patent rights. He estimated a set of simultaneous equations to measure these joint impacts, controlling for market size, tariff protection, the level of local R&D by affiliates, distance from the United States, and investment incentives and disincentives provided by local authorities. This was done for a panel of 46 destination countries over the period 1989-1992. The index of patent strength was the same as that in Maskus and Penubarti (1995).

Table 3 lists his preferred specifications, with coefficients transformed into elasticities. From these results it seems that FDI, as measured by the asset stock, reacts positively to patent strength in developing countries. The data suggest that a one-percent increase in the degree of patent protection would expand the stock of U.S. investment in that country by 0.45%, other things equal. This elasticity is significantly positive and is second in magnitude only to the impact of incentives. While these results need to be subjected to robustness tests, they suggest that FDI is sensitive to IPRs.

Source: Adapted from Maskus (1998)
Note: ^a Coefficient is not significantly different from zero. Asset stock is total assets of foreign non-bank affiliates of U.S. parents in $ millions; Affiliate sales is total sales of foreign affiliates in $ millions; Intrafirm exports to affiliate is U.S. exports shipped to affiliates in $ millions; Patent applications is number filed in the host country; Real GDP in the host country is in $ billions; Tariff level is tariff revenues divided by total imports; Affiliate R&D is expenditure on R&D by foreign affiliates in $ millions; Distance is kilometers of capital city from Washington, DC; Incentives is the number of affiliates that received tax concessions in the host country divided by the number that received tax concessions in all the sample countries; Disincentives is number of affiliates required to employ a minimum amount of local personnel divided by the number of affiliates that are so constrained in all the sample countries; Patent strength is an endogeneity-corrected index of patent laws and enforcement.

This analysis points out that, in theory, investment and technology transfer do not necessarily expand with stronger intellectual property rights, but there is emerging evidence in favor of that view. It is increasingly assumed around the globe that FDI and licensing are beneficial for the recipient country. As discussed in this section, there is a strong presumption in this direction but it is not a necessary outcome in all situations. Rather, it is important that such flows result in stronger competition on local markets, which tends to promote long-run gains. After a brief review of the potential benefits and costs of these activities, I discuss components of a broad policy framework for raising the likelihood that stronger IPRs contribute to greater dynamic competition.

Although their impacts differ across countries, FDI and licensing bear great promise for improving efficiency and expanding growth in developing countries, particularly those that are scarce in capital, are far from the efficient production frontier, and have limited managerial and entrepreneurial talents. These flows provide access to the technological and managerial assets of foreign MNEs, which provide both a direct spur to productivity and significant spillover benefits. These benefits from diffusion obtain through several mechanisms, including the movement of trained labor among firms, the laying out of patents, product innovation through the legitimate "inventing around" of patents and copyrights, and the adoption of newer and more efficient specialized inputs, such as software, that reduce production costs. Further, competition with subsidiaries of efficient international enterprises can stimulate local entrepreneurship and innovation. There may also be beneficial demonstration effects for local firms.

Thus, exposure to competition-enhancing FDI and licensing should improve the knowledge base of the economy and move it toward the globally efficient production frontier. There is clear evidence that developing countries suffer from lagging labor productivity and managerial efficiency, related in part to a failure to adopt newest technologies (Trefler, 1995; Baumol, et al, 1992). Recent experiences in numerous developing economies indicate that liberalization of trade policies and investment regimes can have significantly positive growth impacts in the medium term, even if there is some initial economic adjustment period. Further, a major source of relatively rapid economic growth and industrial restructuring in East Asia in recent decades has been access to foreign technologies through both licensing and FDI in addition to importation of advanced machinery and other technical inputs (World Bank, 1993). Additional benefits include access to a wider variety of specialized products, inputs, and technologies, a deeper and better-trained skilled labor pool, and rising real wages.

These beneficial impacts of inward FDI and technology transfer do not come without costs. If there are not important linkages to other economic sectors, FDI may operate in enclaves and have few spillovers into technologies adopted and wages earned by local firms and workers.² This limited diffusion could be insufficient to compensate the economy for the profits taken out by the MNE. That is, because profit repatriation and license fees are the payments emerging countries make for incoming capital, technology, and advanced producer services, the terms of this exchange could be unfavorable in a social sense, if not in a private sense. This situation is exacerbated to the degree that MNEs engage in abusive practices of their protected market positions in exploiting stronger IPRs. Such abuses could emerge in setting restrictive licensing conditions, requiring technology grant-backs, engaging in tied sales, tying up technology fields through cross-licensing agreements, establishing vertical controls through distribution outlets that prevent product competition, price discrimination, and predation against local firms. Thus, countries could find certain sectors of their economies coming under increasing control of MNEs through exploitation of their specific advantages, including brand names, patented technology, marketing skills, and economies of scale.

While these costs are possible, there is little evidence that they are systematic problems in many countries. Fundamentally, they stem from an economy’s failure to build a policy system that promotes the maximum gains from FDI. For instance, enclave production emerges when the subsidiary is encouraged to produce only for export rather than to compete locally. Firms that are provided access to local and regional markets are more likely to erect complementary business systems, involving production, distribution, and services, that compete widely in the economy and generate spillover benefits. Abusive practices are possible only to the extent that monopoly positions are protected and not disciplined. Many countries have not yet developed appropriate competition rules to deal with these issues.

Seen properly, IPRs do not necessarily generate monopoly market positions that result in high prices, limited access, and exclusive use of technologies. They are more similar to standard property rights, in that they define the conditions within which a right owner competes with rivals (UNCTAD, 1996). Except in particular sectors, cases are infrequent in which a patent holder or copyright owner becomes a strong monopolist. There are still competing products and technologies, including new ones that do not infringe the property right. In this context, much depends on the scope of the product and process claims protected and on the technical characteristics of the invention. For example, narrow patent claims are relatively easy to invent around in generating follow-on innovation.

Thus, IPRs encourage dynamic competition, even if they sometimes diminish static competition among existing products. Advocates of strong IPRs maintain that they create competition with long-run consumer benefits. For example, survey evidence indicates that patent disclosure requirements are significant mechanisms for diffusing technical information to competitors within a short period (Mansfield, 1985). The information may then be used to develop a new product or process that competes with the original. This incremental nature of innovation is a key fact in most technical progress and generally builds dynamic competition rather than investing impenetrable market power. Thus, IPRs can raise imitation costs but likely do not significantly slow down competing product introduction. Moreover, patents and trademarks provide greater certainty to firms, lower the costs of transferring technology, and facilitate monitoring of licensee operations. Additional licensing could then result in greater adaptive innovation in user firms.

In this view, stronger IPRs in developing economies promise long-term benefits as they attract FDI and licensing and encourage follow-on innovation and technology spillovers. This outcome is only likely to emerge if the implementation of stronger IPRs is accompanied by complementary policies that promote dynamic competition.

Freer market access, together with sensible competition rules and related regulatory systems, promise to promote the greatest net benefits from incoming investment. Thus, economies that wish to increase their attractiveness to foreign investors would be advised first to undertake significant market liberalization. While the Uruguay Round committed most countries to cutting trade barriers, further reduction of tariffs and removal of NTBs on a credible schedule would provide an important signal to foreign investors. Regional trade integration, particularly with developed economies that could be the source of additional FDI, could assist in this process. However, such agreements also bear potential for trade and investment diversion and should be considered carefully in each instance.

Developing countries should also establish and encourage rights of establishment in services, in light of the complementary nature of FDI in production and services with trade. Removal or rationalization of investment regulations, such as equity restrictions, content requirements, and limitations on profit repatriation, would expand incentives to invest. It is likely that such regulations generate net welfare losses for the countries imposing them. Finally, privatization of state-owned enterprises could attract further capital as it raises domestic competition.

It is important for emerging economies to pursue sound and stable macroeconomic policies. Development of modern and efficient infrastructure could be instrumental in promoting agglomeration gains that attract cumulatively higher amounts of both domestic and foreign investment. There is also evidence that FDI flows are sensitive to international variations in taxes and incentives (Grubert and Mutti, 1991). While this provides some argument for fiscal advantages, such as tax holidays and accelerated depreciation allowances, it clearly suggests the gains from establishing relatively low tax rates and uniform tax treatment of all investors without discrimination. Certainty and stability in taxes are more effective in promoting investment than are discriminatory and arbitrary policies, while uniform tax schedules can generate considerable efficiencies in resource usage.

A critical component of any program to attract high-quality FDI and technology transfer is the development of a strong indigenous technological capacity. This calls for public and private investments in education and training and the removal of impediments to the acquisition of human capital. It also points toward the development of national innovation systems that promote dynamic competition (UNCTAD, 1996). Such programs include support for basic research capabilities, removal of disincentives for applied R&D and its commercialization, establishment of incentive structures to help stimulate local innovation, and access to scientific and technical information that exists within the global information infrastructure.

Finally, intellectual property rights are important in technology development programs. In implementing stronger IPRs, emerging economies need to find an appropriate balance between needs for technology acquisition, market access, and information diffusion. Most nations will wish to adopt a set of IPRs that do not significantly disadvantage follow-on inventors and creators, allowing sensible fair-use exemptions, issuing compensated compulsory licenses under tightly defined conditions, and carefully defining the scope of protection. Furthermore, it will be important to implement effective competition rules to ensure that IPRs systems are pro-competitive. Each of these policy initiatives requires the development of considerable administrative and judicial expertise. For example, countries may wish to monitor the terms of key technology licensing agreements or to intervene in contracts for the development of indigenous public resources.

This paper has reviewed theory and evidence on how intellectual property rights may influence decisions on FDI and technology transfers. The message is that, while there are indications that strengthening IPRs can be an effective incentive for inward FDI, it is only a component of a broader set of factors. Policy makers should recognize the complementarities among IPRs, market liberalization and deregulation, technology development policies, and competition regimes. These are complex issues, leading to complicated tradeoffs for market participants. Governments may wish to devote considerable attention and analysis to devising means for assuring their countries will achieve net gains from stronger IPRs and additional IPRs and licensing over time.

In this context, considerable scope remains for research into the linkages between IPRs and FDI. The empirical evidence to date suffers from three primary problems. First, data on international FDI flows remain scarce. Beyond the United States, few countries publish more than minimal information on inward and outward investment and the operations of MNEs in terms of employment, sales, and intra-firm trade. In the intellectual property area, the need is acute for sectoral breakdowns of investment in as many nations as possible, both as source and host countries. Second, measurement problems are endemic in this area. It is difficult to capture the economic incentives afforded by a system of laws, regulations, and enforcement, such as IPRs, in a meaningful international index. Unlike taxes and tariffs, which establish measurable price wedges that may be removed in assessing their economic impacts, IPRs form part of the business framework and may have variable impacts in different situations. For example, it would be useful for analytical purposes to understand the "tariff-equivalent" price effects of strengthening IPRs, but these would depend on local market structure and collateral regulation. Thus, economists could devote more effort to characterising the competitive impacts of IPRs in different situations, with a view to understanding the resulting incentives for FDI.

A third problem is that econometric model specification to date has been inadequate to delve deeply into the relationships among FDI and IPRs. Virtually all studies of the international economic flows induced by international variations in IPRs have been static in nature, ignoring the inherently dynamic impacts on innovation, diffusion, and FDI. This points again to the need for more extensive data (across countries and sectors and over time) on investment. Moreover, as discussed earlier, econometric models need to account more carefully for the multiple and simultaneous channels through which international firms operate, including investment, trade, licensing, and registering for patents and trademarks. Each of these flows depends on each other and on the evolving structure of IPRs, in ways that economic theory is only now beginning to explore. Thus, considerably more econometric work at the international level is needed to be confident about such impacts. In doing so, however, economists will encounter further data problems, such as scarcity of information about licensing contracts.

Finally, it bears repeating for research purposes that intellectual property rights do not operate in isolation, but rather interact with market structures, competition rules, and deregulation of trade and investment to determine the effective strength of those rights and the resulting incentives for FDI. A substantial, but nevertheless rewarding, research agenda arises for comparative analytical and econometric studies of these linkages across countries.

Aitken, Brian, Ann Harrison, and Robert E. Lipsey (1996), "Wages and Foreign Ownership: A Comparative Study of Mexico, Venezuela, and the United States," Journal of International Economics, Vol. 40, 345-372.

Baumol, William J., Sue Anne Batey Blackman, and Edward N. Wolff (1992), Productivity and American Leadership: The Long View (Cambridge: MIT Press).

Coe, David and Elhanan Helpman, (1995), "International R&D Spillovers," European Economic Review, Vol. 39, 859-887.

Davidson, William H. and Donald G. McFetridge (1984), "International Technology Transactions and the Theory of the Firm," Journal of Industrial Economics, Vol. 32, 253-264.

Davidson, William H. and Donald. G. McFetridge (1985), "Key Characteristics in the Choice of International Technology Transfer Mode," Journal of International Business Studies, Summer, 5-21.

Eaton, Jonathan and Samuel J. Kortum, (1996), "Trade In Ideas: Patenting and Productivity in the OECD," Journal of International Economics, Vol. 40, 251-278.

Ferrantino, Michael J. (1993), "The Effect of Intellectual Property Rights on International Trade and Investment," Weltwirtschaftliches Archiv, Vol. 129, 300-331.

Glass, Amy and Kamal Saggi (1995), "Intellectual Property Rights, Foreign Direct Investment, and Innovation," Ohio State University, manuscript.

Grubert, Harry and John Mutti (1991), "Taxes, Tariffs, and Transfer Pricing in Multinational Corporate Decision Making," Review of Economics and Statistics, Vol. 71, 285-294.

Helpman, Elhanan (1993), "Innovation, Imitation, and Intellectual Property Rights," Econometrica, Vol. 61, 1247-1280.

Hoekman, Bernard (1997), "Focal Points and Multilateral Negotiations on the Contestability of Markets," in K.E. Maskus, P. Hooper, E.E. Leamer, and J.D. Richardson, eds., Quiet Pioneering: Robert M. Stern and His International Economic Legacy, (Ann Arbor: University of Michigan Press), 171-192.

Horstmann, Ignatius and James R. Markusen (1987), "Licensing Versus Direct Investment: A Model of Internalization by the Multinational Enterprise," Canadian Journal of Economics, Vol. 20, 464-481.

Lai, Edwin L.C. (1998), "International Intellectual Property Rights Protection and the Rate of Product Innovation," Journal of Development Economics, Vol. 55, 115-130.

Lee, Jeong-Yeon and Mansfield, Edwin (1996), "Intellectual Property Protection and U.S. Foreign Direct Investment," Review of Economics and Statistics, Vol. 78, 181-186.

Mansfield, Edwin (1985), "How Rapidly Does Industrial Technology Leak Out?" Journal of Industrial Economics, Vol. 34, 217-223.

Mansfield, Edwin (1993), "Unauthorized Use of Intellectual Property: Effects on Investment, Technology Transfer, and Innovation," in M.B. Wallerstein, M.E. Mogee, and R.A. Schoen, eds., Global Dimensions of Intellectual Property Rights in Science and Technology, (Washington, DC: National Academy Press, 1993), 107-145.

Mansfield, Edwin (1994), Intellectual Property Protection, Foreign Direct Investment, and Technology Transfer, International Finance Corporation, Discussion Paper 19.

Mansfield, Edwin (1995), Intellectual Property Protection, Direct Investment and Technology Transfer: Germany, Japan, and the United States, International Finance Corporation, Discussion Paper 27.

Maskus, Keith E. (1998), "The International Regulation of Intellectual Property," forthcoming in Weltwirtschaftliches Archiv, June.

Maskus, Keith E. and Denise Eby-Konan (1994), "Trade-Related Intellectual Property Rights: Issues and Exploratory Results," in Alan V. Deardorff and Robert M. Stern, eds., Analytical and Negotiating Issues in the Global Trading System, (Ann Arbor: University of Michigan Press), 401-446.

Maskus, Keith E. and Mohan Penubarti (1995), "How Trade-Related Are Intellectual Property Rights?" Journal of International Economics, Vol. 39, 227-248.

Rockett, Katharine (1990), "The Quality of Licensed Technology," International Journal of Industrial Economics, Vol. 8, 559-574.

Sherwood, Robert M. (1990), Intellectual Property and Economic Development, (Boulder, CO: Westview Press).

Smith, Pamela J. (199), "Are Weak Patent Rights a Barrier to U.S. Exports?" Journal of International Economics, forthcoming.

Taylor, M. Scott (1994), "Trips, Trade, and Growth," International Economic Review, Vol. 35, 361-381.

Teece, David J. (1986), The Multinational corporation and the Resource Cost of International Technology Transfer, (Cambridge: Ballinger).

Trefler, Daniel, (1995), "The Case of the Missing Trade and Other Mysteries," American Economic Review, Vol. 85, 1029-1046.

United Nations Conference on Trade and Development (1996), The TRIPS Agreement and Developing Countries, (New York: United Nations).

Vishwasrao, Sharmila (1994), "Intellectual Property Rights and the Mode of Technology Transfer," Journal of Development Economics, Vol. 44, 381-402.

World Bank (1993), The East Asian Miracle: Economic Growth and Public Policy, (Oxford: Oxford University Press).

Yang, Guifang and Keith E. Maskus (1998), "Intellectual Property Rights, Licensing, and Innovation," University of Colorado, manuscript.

1 | This is a relative comparison. It is not that raising trade barriers would attract FDI, but rather that high tariffs in relation to fixed costs are associated with FDI.

2 | For example, Aitken, et al, (1996) provide evidence that U.S. multinationals operating in Mexico and Venezuela pay significantly higher wages than average to their own employees but these wage impacts have not spread to other parts of the economy.

Contact author:
Professor Keith Maskus
Department of Economics
Campus Box 256
University of Colorado
Boulder, CO 80309-0256 USA
Telephone: (303) 492-7588
Fax: (303) 492-8960
Email: Keith.Maskus@colorado.edu.

Further details and a list of publications are available from:

Executive Assistant
Centre for International Economic Studies
University of Adelaide
Adelaide SA 5005 AUSTRALIA
Telephone: (08) 8303 5672
Facsimile: (08) 8223 1460
[International prefix: (+61 8)]
Email: cies@adelaide.edu.au

Most publications can be downloaded from our Home page: http://www.adelaide.edu.au/cies