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Midterm_Solution - Applied Economics and Management Prof...

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Applied Economics and Management Prof. Aija Leiponen Innovation Strategy (AEM 437) MIDTERM EXAM March 16, 2006 Try to formulate your ideas before you start answering each question. Sketching the main points first on a scratch paper is a good technique to keep your answers clear and crisp. Make sure you don’t spend more than half the time on the first four short questions. Also, pay attention to your hand-writing. Anything I can’t read will not be graded.
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Answer the following five short questions (5 points each. Get to the point quickly. Don’t spend more than 1 hour on the top section before tackling the essays!): 1. Why do industrialized nations subsidize R&D activities? To increase social capital This paper reconsiders the well-worked topic of strategic trade policy, but we approach the topic from a novel and important perspective. We observe that previous work on strategic trade policy with regard to R&D subsidies, starting with the seminal paper by Barbara Spencer and Jim Brander (1983), has proceeded under the implicit assumption that firms have perfect property rights to the results of their R&D investments. In reality, of course, the protection of intellectual property rights (IPRs) is not perfect. So it is natural to consider optimal choices for these policies in tandem rather than examining R&D subsidy policy in isolation. We show that the level of IPR protection can have important implications for a government¡¯s incentives to intervene in the R&D decisions of domestic firms.We treat the level of IPR protection as exogenous, and consider how weak IPR protection may affect the case for an R&D subsidy in an international duopoly setting. When IPR protection is perfect, the model is identical to the original Spencer and Brander setup, and exhibits its well-known features. A firm¡¯s profits rise when its rival undertakes smaller amounts of R&D, and so governments seek to reduce the R&D levels of rival firms with their R&D policies. As a firm¡¯s best response to an increase in R&D by its rival is to reduce its own R&D (i.e., R&D reaction curves slope down), the domestic government will wish to subsidize R&D because, in providing the domestic firm with an incentive to do more R&D, the government is able to discourage R&D activity be the foreign rival firm. However, in the presence of imperfect IPR protection, a novel force comes into play in determining government incentives to intervene in firm R&D choices: a rival¡¯s R&D now directly reduces one¡¯s own costs as well. If IPR protection is sufficiently weak, we show that R&D reaction functions will in fact slope up, so that a prediction of R&D subsidies will again obtain. But now it is fore precisely the opposite reason found in the original Spencer and Brander logic: the domestic government will wish to subsidize its firm¡¯s R&D in the presence of sufficiently weak IPR protection, because in providing the domestic firm with an incentive to do more R&D, the government is able to encourage R&D activity
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