Incentives for cost reducing innovations under quantitative import restraints

Abstract

The effect of quotas on fmns' incentive to invest in cost-reducing R&D is studied in a two-stage price-setting duopoly. A domestic and a foreign firm choose initially R&D efforts 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 fmn faces less competition than under free-trade and chooses to invest less in R&D. Contrarily, the constrained foreign fmn invests more in R&D as the negative strategic effect of a reduction in its cost is now absent. These results differ from the Coumot duopoly case in which R&D expenditures are lower for both fmns. We also show that as the quota becomes more restrictive, the domestic fmn increases and the foreign fmn decreases its expenditures in R&D. Finally, we show that domestic welfare is a1ways higher under free-trade than under any quota regardless of the degree of product substitutability