Incentives for Cost Reducing Innovations Under Quantitative Import Restraints

Abstract

The effect of trade quotas on firms’ incentive to invest in cost-reducing R&D is studied in a two-stage price-setting duopoly game. A domestic and a foreign firm first choose R&D levels and then set the prices of their differentiated products in the domestic market. With a quota imposed at, or close to, the free-trade level of imports, the domestic firm faces less competition than under free-trade and invests less in R&D. Contrarily, the constrained foreign firm invests more in R&D as the negative strategic effect of a reduction in its cost is now absent. These results differ partially from the Cournot duopoly case in which R&D expenditures are lower for both the firms. As the quota becomes more restrictive, the domestic firm increases and the foreign firm decreases its expenditures on R&D. Domestic welfare is always higher under free-trade than under any quota regardless of the degree of product substitutability.

The authors acknowledge the comments received from Peter Neary and other participants at the CEPR ERWIT meeting in Thessaloniki, 1995, the Jornadas de Economía Industrial in Madrid, 1995, the ADRES conference at Strasbourg, June 1996, FEDEA and two anonymous referees. Kujal and Petrakis acknowledge support from the DGICYT grant PB95–287 and financial support from the grant Acciön Integrada Hispano-Portuguesa 1996, 29 B. Cabral acknowledges financial support from the grant Açōes Integradas Luso-Espanholas E-63/96.