Los criados

versus foreign licensing

Markusen (1995) and Ethier & Markusen (1991) present a two-period model of a multinational enterprise (MNE) that wishes to exploit a technology (product formula, brand) in a foreign market. The MNE can do so by licensing it to a foreign firm or by setting up local subsidiary, but not by exports.

The assumptions are:

• The licensee needs one period to master the technology. At the beginning of the second period the MNE and the licensee make simultaneous moves, choosing whether to continue their original relationship. The licensee pays a license fee L_i in each period i (i=1,2).

• No binding licensing contracts can be written to prevent the MNE or the licensee from defecting in the second period. The MNE can defect by issuing a license to a second firm in period 2. The licensee can defect by starting its own firm on the basis of the MNE's technology.

• If the MNE or the licensee defect, then the original licensee and a new licensee will compete as duopolists in the second period.

• For starting production with the technology the licensee or the MNE incur a physical capital cost F. If one partner defects, that partner must incur the additional costs of F, the non-defecting partner retaining the original.

Commercial exploitation of the technology yields a total amount of rents in each single period. The total amount of rents differs in the three possible scenarios:

R: rents when the original license contract is repected M: rents when the MNE sets up a local subsidiary

D: total rents for the two duopolists when the MNE and/or the licensee defect.

Over the 2-period scenarios - license contract, local subsidiary, defection/duopoly - cumulative net rents amount to (2R - F), (2M - F) and (R + D -2F), respectively.

• Markusen adds two numerical assumptions on the total rent level in the scenarios. Because establishing a business abroad brings additional costs compared to local producers (cf. Z costs in the text box on p.21), it holds that: R > M. Furthermore, duopoly creates more price

competition, resulting in: M > D. Both assumptions mean that cumulative net rents over the two periods must have the following relation: (2R - F) > (2M - F) > (R + D -2F) .

• The licensee only respects the contract if his second-period earnings are at least as high as what he can earn by setting up an independent production line. That is, if (R - L2)  (R - F).

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Defection depends on opportunity costs. For the MNE, the alternative is nominating a second licensee, incurring additional FF investment, and receive lower rents in a subsequent duopoly situation. Hence, it is arguable that the MNE's non-defection condition should be L2 (D/2 - F) instead of the condition formulated by Markusen (HK). This implies that the non-defection condition for the licensee is (R - L 2)  (D/2 - F).

Markusen assumes that the MNE respects the contract if its licensing fee is at least equal to L2  (R - F), its payoff from defecting.87

It is now possible to derive the defection conditions and the distribution of total rents in each of the scenarios. Combining non-defection conditions of both contractants, the license contract is only respected in the second period if: R < 2F.

If the R < 2F condition holds, the multinational will license and extract all available 2-period rents. In the second period, the fee L2 = F is the largest fee that the MNE can extract without causing defection. It leaves the licensee rents that amount to: (R - L2) = (R - F). A rational MNE will therefore extract most rents in the first period when defection is not possible:

L1 = (2R - F). In the end, the MNE has collected all available 2-period rents: (L1 + L2) = 2R. In the case that R  2F, the licensee will defect, and a duopoly game results in the second period. The original licensee, now on its own, generates a net second-period profit of (D/2 - F), while the new licensee generates (D/2), using the original capital stock F. Knowing that defection is coming in period 2, the MNE can maximally charge the licensee a first-period fee of

L1 = (R + D/2 - F), thus taking away the latter's possible second-period profits. The new licensee is charged a fee of L2 = D/2.

Hence, total 2-period profit of the MNE amounts to: (L1 + L2 - F) = (R + D - 2F). While the MNE earns all rents in the duopoly case, it also incurs additional fixed costs, while some rents are dissipated by duopoly competition. The upshot is that, if R  2F holds, the MNE will seek to avoid the duopoly outcome and instead set up a subsidiary.

Finally, consider the situation that the MNE technology (product formula, brand) is a pure knowledge-capital technology for which it holds that F  0. It implies that the licensee can costlessly enter production in the second period after one period of learning by doing. With F  0 it is clear that the R < 2F will fail to hold, and licensing will not sustain itself. The result is that the MNE, right from the beginning, chooses a costly subsidiary over a rent-dissipating licensing contract.

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An important international forum for such debates was the so-called Voorburg Group of national statistics bureaus in European countries. The EU launched an initiative to improve registration of services production in member countries (Eurostat 1998). In the Netherlands, CBS (Statistics Netherlands) is to take over registration of international trade in services from De Nederlandsche Bank. A major effort is invested in designing and validating volume indicators for international trade in services (Gras 1998).

89 _{Some caution is warranted as coverage of these items varies from one country to another.} 90

E.g. Boddewyn et al (1986); Dunning (1989, p. 39).