The effect of subsidies to product innovation on international competition*

Abstract

Models of vertical product differentiation allow for the analysis of international trade in the presence of country asymmetries in terms of product qualities, technology, costs, market size, and income. In the presence of such asymmetries, national industries will either be market leaders or be lagging behind in the international market place in terms of their product qualities. The resulting asymmetry in profits creates powerful incentives for lagging industries as well as their national governments to reverse this situation to their advantage, i.e. to induce "leapfrogging" in terms of product qualities. This paper presents an analysis of subsidies to investment in product quality as a facilitating device for leapfrogging. Investment in product quality is interpreted as innovation investment or expense, which includes but is not limited to R&D investment. Its result is a better, different product, i.e. product innovation. It is found that subsidies to quality investment can induce leapfrogging and thereby increase domestic profits, consumer surplus and welfare. In the case of leapfrogging, the domestic firm will enjoy profit increases that are larger than the necessary subsidy costs. The strategic aspect of the subsidy policy lies in its function as a facilitating device for a radical change of the initial market structure, where the domestic firm gains an international leadership position.