Globalization, R&D and Endogenous Choice of Technology

This paper constructs a dynamic scale-free North-South model of trade with endogenous innovation. In the North two types of R&D races take place simultaneously within each industry. One is local-sourcing-targeted R&D race, which results in the winner firm manufacturing in the North. The other is outsourcing-targeted R&D race, which culminates in the winner firm manufacturing in the South. In equilibrium, manufacturing costs are lower in the South, but engaging in outsourcing-directed R&D is more costly than local-sourcing directed R&D. Entrepreneurs optimally choose the degree of challenges associated with their R&D projects and thereby determine their ex-post manufacturing productivity levels. More challenging R&D projects require more resources ex-ante but generate more labor saving in manufacturing ex-post. We study the effects of globalization by considering a reduction in the resource-requirement in outsourcing-targeted R&D (triggered by reduced communication and transportation costs). Such a change reduces the North-South wage gap and increases the mass of outsourcing industries. The aggregate innovation rate increases despite the possibility of a fall in the rate of local-sourcing directed R&D. We also investigate the effects of Southern policies towards FDI. We find that subsidies that reduce the cost of multinational manufacturing in the South may have an adverse effect by reducing the measure of Outsourcing industries. On the other hand subsidies that facilitate the technology transfer efforts of Northern firms unambiguously increase this measure. An increase in either type of subsidy raises the aggregate innovation rate and diminishes the North-South wage gap.