Trade Liberalization and Optimal R&D policies with Process Innovation.

We set up a theoretical framework to discuss the impact of trade liberalization and R&D policies on domestic exporting firms' incentive to innovate and social welfare. In this framework, exporting firms invest in R&D to reduce their production costs and, in return, receive R&D subsidies from the government. While firms target at maximizing their profits, the government aims to maximize the social welfare. We consider different settings of firm competition to explore their strategic behaviors as well as the government's strategic behavior at the policy stage. We find that trade liberalization in the foreign market always increases firms' output sales and social welfare and, in most cases, leads to higher R&D investments and productivity at firms as well as industry level. When firms are independent monopolies in the overseas market, it is optimal for the government not to provide any R&D subsidy. When goods are close substitutes, the social optimum can be achieved as a Nash equilibrium by applying an optimal R&D tax. Trade liberalization induces a higher R&D tax rate to be levied on firms. When firms also conduct business in the home market, it is always optimal for the government to provide firms with a financial support to their R&D activity. While this R&D subsidy is decreasing in the trade cost when firms are independent monopolies, its monotonicity in the trade costs is determined by the convexity of the R&D cost function when firms produce close substitutes.