Phases of Innovation and Imitation

Phases of Imitation and Innovation in a North-South Endogenous Growth Model
Author(s): David Currie, Paul Levine, Joseph Pearlman and Michael Chui
Source: Oxford Economic Papers, Vol. 51, No. 1, Symposium on Trade, Technology, and Growth (
Jan., 1999), pp. 60-88
Published by: Oxford University Press
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( Press 1999
OxfordUniversity OxfordEconomicPapers51 (1999), 60-88 60
Phasesof imitationand innovationin a

North-Southendogenousgrowthmodel
By David Currie*,Paul Levinet,JosephPearlmanjand Michael

Chui?
* LondonBusinessSchooland CEPR
of Economics,University
t Department of Surrey,
Guildford,
SurreyGU12 5XH,
UK and CEPR
I LondonGuildhallUniversity
and LondonBusinessSchool
? LondonBusinessSchool
A North-Southendogenousgrowthmodelis developedto examinethreephasesof

Southern development: imitationofNorthern imitation
products, and innovation,and
innovationonly.We showthatthe threephasesexistas possibleequilibriawhich
dependon knowledgespilloversand the ease of imitation. Applyingthe model to
analysethe impactof R&D subsidies,thereare some clearpolicyimplications: (I)
thewelfareeffects of subsidiesin bothblocsdependcrucially
on theSouthernphase;
(II) therearecircumstanceswheretheglobalbenefitsfromsubsidiesto theSouthareso
substantialas to be Pareto-improvingevenwhenfullyfinanced bytheNorth.
1. Introduction
Two keyfeatures thatdetermine tradingpatterns and growthin theglobalecon-
omy are the speed withwhich thepoorer South absorbs knowl-
scientific/technical
edge and management/commercial skills
from the North, and the costin
relative
the South of imitatingcomparedto innovating.Knowledgetransfers can be
increasedor impededbyinternational institutional
arrangements and specificpoli-
cies thataffecteducationand trainingin the South.The incentiveto innovate
ratherthanimitatein the Southwilldependamongstotherthingson the inter-
nationalprotectionof intellectual propertyrightsand on government policies,
including to
subsidies, encourageinnovation in theNorthand South.
This paperexaminestheseissuesbydevelopingan endogenousgrowthNorth-
Southmodeldrivenbyknowledge spillovers.Thismodelis thenusedto analysethe
impact ofvarious R&D subsidies.
Our model buildson theworkofGrossmanand
Helpman(1991) (henceforth G&H), but extendsitin an importantdirection. G&H
develop North-South modelsin whichtheSouthimitates theNorth,but does not
innovate.Suchmodelsincorporate thetraditionalrelationshipbetweenNorthand
South;but theyare less appropriate fortheanalysisof relationships betweenthe
matureindustrial economies(OECD) and the rapidlygrowingeconomiesof the
PacificRim.Table 1 indicateshow SouthKoreaand Taiwan,twoleadingPacific
D. CURRIE ET AL. 61
Table 1 Innovationperformance
R&D/GDP Growth
in R&Dt Patentsgrantedt
1993(%) Ranking 1989-93(%) Ranking 1992-93 Ranking
Korea 2.08 11 9.72 10 9.25 10
Taiwan 1.78 13 16.71 4 66.46 1
UK 2.11 10 - 1.86 29 7.86 12
US 2.77 4 - 1.05 28 20.53 6
growthin totalexpenditure
t Annualrealcompoundpercentage of R&D.
$ Averageannualnumberofpatentsgrantedto residents
per 100,000inhabitants.
Source:The WorldCompetitiveness
Report1995.
Rim economies,are now emerging as centresof R&D activity and new product
development. Comparing the shareof R&D in
expenditure GDP, theannualcom-
in
poundgrowth R&D expenditure, and patentsgranted to residents ofTaiwanand
SouthKoreawithtwoothertypicaladvancedOECD countries, theUSA and UK,
we can see thattheformer countriesarebecominga focusofinnovation in itsown
right.' To analyse the interaction between Northern innovators and Southern
imitators and innovators thusrequiresa modelthatallowsforthe possibility of
bothimitationand innovationin thelatterregion.Developinga modelwiththis
featureis thecentralcontribution of thispaper.
Variousothermodelsalong'new' growththeorylineshavebeen developedto
describeNorth-Southinteractions. Initially theseadoptedthetraditional focusof
theSouthas notbeingan innovator(G&H, Ch. 11; Segerstrom et al. 1990).This
has been followedby 'leapfrogging models'whichassumethatthe South,while
starting offas an imitator,may become an innovator instead(Chou and Shy,1991;
Barroand Sala-i-Martin, 1995; Breziset al., 1993).Segerstrom (1991), in a closed-
economymodel, shows that an equilibrium withbothimitationand innovation
involvingcollusionbetweenfirmscan exist.The prospectof collusionthenpro-
videsan incentive to engagein costlyimitation. In theNorth-South modelofG&H
it is theabsenceoffactorpriceequalizationand theabilityofSouthernfirms with
lowerwage coststo priceNorthernfirmsout of the marketsthatprovidethis
incentive, and we retainthisstructure.
Our model is the firsttwo-blocendogenousgrowthmodel to examineand
integrate threephasesof development: innovationin theNorthwithimitationin
the South;innovationin the Northwithboth imitationand innovationin the
South; and finallyinnovationin both blocs. The key factorsthat determine
whichphase occursas an equilibriumare first,the degreeto whichcopyingis
easierthan innovationfora givenstockof knowledgecapital;and second,the
relativestocksof knowledgecapitalper worker.The latterin turndependson
the rateof diffusion of one region'sinnovationsinto the knowledgecapitalof
See Chui et al. (1996) forfurther

discussionof thesedevelopments.
62 PHASES OF IMITATION AND INNOVATION
theother. Figure1 inSection 3 belowsummarizes thisdependency. Theparameter

r, is therateofassimilationofNorthern innovationsby theSouth intoSouthern
knowledge capitalwheren--+oc is theextreme ofinstant assimilation.Thepar-
ameter a/,laislowertheeasieritistocopyratherthaninnovate intheSouth.Thus
forsufficiently lownand a ofimitation dominates. Foran intermedi-
ac/a, region
aterange, a regionofbothinnovation andimitation dominates. Thesetwopar-
ameters, together withthe other parameterscharacterizingconsumer preferences,
determine thebalanceintheSouthbetween innovation andimitation andenable
us to address theimpactofgovernment intheformofsubsidies.
Thestructure oftherestofthepaperis as follows.
Section 2 setsoutourmodel
andfocuses onthetreatment
particularly ofknowledge capitalandspillovereffects.
Section3 examines thesteady-state and
equilibria, the transitional
dynamics are
discussed in Section4. Section5 examines theeffectofsubsidies on growth and
Section6 provides a welfare ofthesesubsidies
analysis inallthreephasesofdevel-
opmentin theSouth.Section7 provides conclusions andsuggestions forfuture
research.
2. A North-South
modelwiththreephasesofdevelopment
Therearetworegions: NorthandSouth.Botheconomies consist
ofa monopolis-
tically production
competitive sector
and a sector
competitive conducting R&D.nN
varieties
wereinventedandarenowproduced intheNorth. nsareproduced inthe
Southandofthesensoriginated intheSouthfrom innovationandnswerecopied
fromtheNorth(wherethesubscripts i andc representinnovation andcopying
Thusthetotalnumber
respectively). ofvarieties
availableto consumersin both
regionsis n = nN+ ns= n + ni + n. Thedemand sideofthemodelis entirely
standard:consumershaveidentical world-wide
preferences andmaximize a utility
functionwhichislogarithmicina Dixit-Stiglitz
indexwithelasticity
ofsubstitution
S= 1/(1- a) > 1, wherea E (0,1) is thetasteparameter.2 Aggregatingover
and
regions writing world nominal as
consumptionE gives total
world demand
forvarietyj wherever
itis producedas3
Xi= nEpI j [0,n] (1)

dj',
JO
Thenovelfeatures
ofthemodelareonthesupply side.Labouristheonlyfactor
of production
and one unitproducesone unitof output.Thentheoperating
of firmj producing
profits j in bloc b is givenby ir (p=
variety = - w)x;
2A lowervalueofa represents
a greater
tasteforvariety
byconsumers.
Appendix1,Section1.1,givesfull
details
oftheconsumers'
problem.
3 Thegeneral
notation
adopted denotes
throughout ofvariety
supply j byblocbby b = N,S ata price
x>b;
or iftheorigin
is irrelevant.
G&Hchoosethenormalization
E = 1.Weprefer
thenormalization
p1 pj theNorthern to
thatsets wage unity 1,Section
(seeAppendix 1.2).
D. CURRIE ET AL. 63
b = N, S. The Northernfirm'sprofit-maximizing
price and profitssubjectto
demand by(1) arethengiven
given by
N= PN wN
Pi a
rj = Nr = (1 - a)pNxN (2)
i.e.,allvarieties
in theNorthhaveequalpricesandprofits.ForSoutherninnovating
firmspricingand profits are analogousto (2) and givenby
wS
s = 7rs (1 - a)p~xS (3)

-
Following G&H for Southern or
copying imitatingfirmswe distinguish the
narrow-gap case,awN < ws < wN,wherethereexistsonlya smallcostadvantage
in theSouth,and thewide-gapcase wherews < awN. For thelattercase copying
firmscan chargethefullmonopolypricegivingpriceand profits
S
Pc,J= Pc --
7
= 7rc= (1 - a)psxc(4)
In thenarrow-gapcase theSouthernfirmchargesa limitpricejustsufficient
to
eliminatea potentialNorthernrival,i.e.
S S N
PC,] = w
P-
r,= S (wN- w5)xs= (5)
Now considerthe R&D sectors.The ratesof productionof new goods in the
Northand South,and thetransfer ofproduction
to theSouththroughcopyingare
givenby
nc+ N K
*N _LNKN
? a
L
a/3Ks
>(6)
where
ac ac c
LSKS
s s
C I a< a
LN,Ls,andLS;KN,andKs denotelabouremployed
inresearch
andcopying
sectors,and knowledge capitalperunitoflabourin Northand Southrespectively.
The assumption ac < a capturestheidea thatcopyingis easierthaninnovationfor
a givenstockofknowledge capital.Similarly > 1 allowsforinnovation in
activity
theSouthto be lessefficientthanin theNorth.Forthetimebeing,we treat as
ac
constantbutlaterin Section3 we shallassumethat is a function oftherelative
ac
size of thecopyingsector,nf/n.
The treatment of knowledgecapitalis centralboth in generalto endogenous
growth modelsofthisgenre,and in particular
in ourmodelwherewe allowforthe
possibleco-existence ofinnovation and imitation in theSouth.The generalidea is

thateach activityin the R&D sectorgivesriseto both a new blueprintand an
additionto society'sstockof knowledgecapital,whichcontainsnew ideas and
information thatwill be usefulto latergenerations of innovatorsand also imi-
tators.4G&H proxyknowledge capitalbythemeasureofvarieties ofdifferentiated
goods. This leads to the resultthat growth increases with increasing population
size.Generalobservation as wellas empirical work(Jones,1995)rebutthisresult.A
morerealistic conclusionarisesfromtheobservation thatinnovative research arises
frominteractions betweenpotential innovators. Thelargerthetotalpopulation, the
smalleris theprobability ofinteracting withanyone innovator.5 Thissuggests that
knowledge capitalis likelyto be proportional to thedensityofvarieties withinthe
population. If we make this modification to the G&H model, this
defining constant
of proportionality as 0, thenall theresultsremainunaltered apartfromreplacing
population bysize 0. If0 is thesame forall then
countries, growth is identical forall
countriesand the scale effect, thatgrowthincreasesas populationsize increases,
disappears.
Turningnow to thefunctional formsused forknowledge capital,it is usefulto
contrasttheeffects of knowledge capitalwith and without cross-region spillovers
whentwo regionsengagein innovationand production.If thereare immediate
spilloversof knowledge capital,so thatknowledge capitalin each regiondepends
on thetotalmeasureofall different varieties,thenin equilibrium bothregionsgrow
at thesamerate.Ifthereareno spillovers, so thatknowledge capitaldependson the
measureofvarietiesin each region,thenin generalone regionwilldominateand
theotherwillgrowmoreslowly.Theseare features analysedbyG&H, and Dever-
eux and Lapham (1994). Thus to ensurethat an equilibriumgrowthpath is
attained,witheach regioninventing a non-zeroproportionof new goods,it is
to a
necessary incorporate spillover effect.How can thisbe accomplished in sucha
way as to account for a Pacific Rim country catching A
up? generalrepresentation
forinnovation knowledge capital(incorporating thedensity effectoutlinedabove)
is thefollowing, adaptedfromGrossmanand Helpman(1990)
K -0 teKN(t- n
KN= 0 [N+
K
n +n+ N" 7) d7j
Ls S(T)
ns+ns s e- s(t-T)nN(r) dr
KS = 0 + ~-
+ni n SN"(7)*
so thattherearespillovers
fromone regionto another,
buttherateofassimilation
of one region'sinnovationsintotheknowledgecapitalof theother,capturedby
4 The generalapproachto modelling knowledge international is takenfromRivera-Batiz

spillovers and
Romer(1991a,b).
5 Porter(1990) suggests thatface-to-face
contactis an importantfactorforthespreadingofinnovative
ideas (see also Breziset al, 1993,fora discussionofthispoint).
D. CURRIE ET AL. 65
0 < KN, nS < oc, is not immediate.In particularthereare gradualspillovers from

Southerninnovativeactivity to the Northand fromvarietiesinventedand pro-
duced in the Northto the South.In the limitas nN= ns--+oc, assimilation is
instantand ifpopulationsare thesame,bothNorthern and Southernknowledge
capital is proportionalto the total number of varietiesin the world,
= n +
n + whicheverregionassimilates theother'sinventions the
nc ni. Clearly
fasterwillbe able to producemorenew goods,and will have a higherstockof
knowledgecapitalin thesteadystate.
We now assumethattheNorthis characterized byan advantagein assimilating
knowledge from
capital therestoftheworld,i.e., ,N > KS.We further simplifyand
accentuatethisfeatureby lettingKN tendto infinity, i.e., the North assimilates
knowledgecapital instantly.6 In orderto reducesubsequentnotation,we set
s i= K. With this assumptionour representation forknowledgecapitalin the
Northreplaces(7) with
KN= 0 n
L+ L+s (8)
Our formulation of knowledgecapital largelyremovespopulationeffectson
growth.It is also straightforwardto showthereare also no size effects on levels
ofrealvariablessuchas thetermsoftradewhenK-* oc. Withlittlelossofgeneral-
itywe therefore assumeequal populations,i.e., LN = LN = 1 in the subsequent
sectionsof the paper.This simplification is unimportant wheninnovationonly
takesplace,as a transformation ofvariablesfromnbto nb/Lb (b - S,N) willreadily
demonstrate. Whenimitation the
occurs, population ratioLs/LN playsa rolein the
results;thisis unsurprising,
becausethegreaterthisratio,thegreateris thelike-
lihoodof imitation bytheSouth.
Now considerthefinancial sectors.Letthestockmarket valueofthetypicalR&D
firmin theproduction sectorsproducinginnovative goodsin theNorthand South
and imitatedgoodsin theSouthbe denotedas vN, and respectively. A new
vi, vc
blueprint in the North costswNa/KN and value maximization requires to be
this
equated with vN. The same argument applies to innovationand imitationin the
Southgiving
N w a
KN
SwS a3
I=KS
S wSacf
vc= KS (9)
We assumeperfect betweenproductionand R&D sectorsin each
capitalmobility
region,but financialautarky
betweenregions.In theNorththetypicalfirmmust
6 With thisassumptioncatchingup by the South occursas but overtaking

can never
is increases,
happen.
takeintoaccountthat,duringtheperiodoftimedt,itwillbe imitatedbytheSouth
h /nNdt. This givestheno-arbitrage
and forcedout of businesswithprobability
condition
*N -.s
S = rN (10)
VN nN
VN
whererbdenotestheinterestrateinbloc b. In theSouthwe musttakeintoaccount
between
arbitrage threeassets: bonds,and theequitiesof firmsproducing
riskless
innovativeand imitated
goods. The no-arbitrageconditionis then
SS .S
+ s=r = + (11)
-7
The modelis closedwitha labourmarketequilibrium
conditionforeach region
=
Kj( Afi)+ nxN LN
+ ns+ X +ns s (12)
aK3-n
The modelsetout above characterizes thethreephasesof development we are

studying: imitationin the South; innovation imitation
alongside in theSouth;and
innovation onlyin theSouth.Imitation(innovation)onlyin theSouthis obtained
bysettingns = 0 (ns = 0) and suppressing thearbitrage
condition(11). Imitation
and innovation together is obtainedfromthefullsetofrelationships.
TheNorthern
innovation-Southern imitationcase is partiallyexaminedin G&H but ignores
internationalspilloversin knowledgecapital,i.e., KN = 9(nN+ and
Ks = OnS/Lsin our formulation.7 Grossmanand Helpman(1990)nc)/LN,
extendtheir
modelto includelags in the diffusion of knowledge.A two-country modelwith
instantassimilation of knowledgecapital(K -- oo) and withinnovationonlyin
bothcountries is studiedbyWilde (1995) whoprovidesan interesting treatmentof
globalstability.
In thetwo phasesinvolving copyingin theSouththereare twopossibleequi-
libria:thenarrow-gap and wide-gapcases.In factin thephasewithimitation and
innovationin theSouthwe can disposeof thelattercase.Thisis summarized as:
1 Thereis no wide-gapequilibrium
Proposition withbothimitationand innova-
tionin theSouth.
The intuitionbehindProposition1 is straightforward.
In a wide-gapequilibrium
thepricesand therefore
theprofits
and valuationofimitatedand innovativegoods
in theSouthwouldthenbe thesame.However,sinceSoutherninnovation is more
costlythanimitation, betweenthesetwoactivities
arbitrage rulesout theformer.
The nextsectionconsidersthesteadystateof theremaining narrow-gap equilib-
riumwithbothimitationand innovationin theSouth.
The moregeneralcase KS = KS(nN, ns) is briefly

examinedin an Appendixto G&H Ch. 11.
D. CURRIE ET AL. 67
3. Thesteady
state
Fromthedemandand pricingequations,(1), (2), (3), and (5) we can writedown
relativedemandrelationships
thefollowing
S - -E
xS
x= i (13)
Now letus introducesomemorenotation.Letw = wS/wNbe theSouth-North

wageratiowhichfrom(13) is equal to thetermsoftradein innovative goods.Let
N = nN/n, S = ns/n,and = 1 - -N - s be thesharesof the threetypesof
cs
productsin thetworegions.Letc = hS/nNbe therateat whichtheSouthcopies
theNorthand letk = KS/KN be theratioofknowledge capitalin theSouthto that
of theNorth.
We now solvefora balanced-growth steady-statein whichtheproductshares
and k are constant,and thetotalmarketvalue of each productionsectoris con-
stant.Thendefining h/n= g, we have
,N
hN -S *N -S -S
--- = -= = = -c= =g (14)
n=
fromwhich
1- _+= Ng (15)
g
follows.Differentiating
Ks w.r.t.timeusingthedefinition
in (7) and putting
I = 0
of k as
givesthesteady-state
k= 1 CNg
(16)
In thesteadystatewe haverN= rs= p wherep is therateoftimepreference of
consumers(seeAppendix1). Thencombining theno-arbitrage
conditions (10) and
(11), theNPV rulesforR&D investment
(9), thepricingequations(2), (3), and (5)
with(13) and (14) gives
-
wf/v?Ksx? kw
7rN/vN= KNxN-
I- -(17) p+g
p+ g + c
7r/vS Ks(1 - w)LaxcSa k(1 - w)-a p+ g
- a)xNacO (1-
- KNW(1
rN/vN - p+=-(18)
g+ c
Thenequating(17) and (18) we arriveat a)a
,(1 - a) a, _ E (1- w)
E = (19)
- f(w)
-
ci a w
say.The function f(w) in (19) can be shownto havea maximumat w = a, and to
be decreasingforw > a which,we recall,is thenarrow-gapcase.Proposition1 tells
us thatthisis therelevant rangeofw forthephaseofimitation and innovation in
the South.Since ac/a < 1 and f(1) = 0, the left-hand side of (19) lies between
f(a) and f(1). f(w) thereforecrossesthisvalue at one pointw E (a, 1). This
narrow-gap solution to (19) is independent nof and is decreasingin a,l/a.
Hencewe havetheproposition:
2 Forthephaseofimitation
Proposition in theSouth,thereexistsa
and innovation
equilibrium
unique steady-state relative w
wage = wSl/wN the narrow-
satisfying
gap conditionw > a. This equilibriumsteadystate is independentof r, but
decreasingin ac/a
The intuitionbehindthesecondpartof thispropositionis as follows.Equation
(19) is a consequenceoftheno-arbitrage conditionbetweenimitation and innova-
tion in the South.This requiresequalitybetweenthe steady-state rateof return
fromR&D investment in thesetwo activities; i.e., r/vs = rv = p g from
(11). Both the relativewage costs and theproductionprofitsare independent of
knowledgecapital, and hence the assimilation parameter K. It follows that the
equilibriumrelativewage at whichtheno-arbitrage conditionis satisfiedis also
independent ofr. Bycontrast, iftherelativeR&D costofa blueprint forimitation
relativeto innovation, ac/a, increases thentheno-arbitrage conditionrequiresthe
relativeimitation-innovation profitsalso to rise.The limitpricingceilingforthe
imitatedgoods and mark-uppricingfor innovativegoods means that this is
achievedby a decreasein the South-Northrelativewage w. As ac/a increases,
thenimitationdeclinesso releasinglabourfromproductionand R&D activities
by a sufficientamountto bringaboutthisdownwardmovement in w.
Equations(15), (16), (17), and (19) together withthesteadystatesoftheequa-
tionsin (12), i.e.
+g)Wt [g+(p+g)
0=(k)g +(P c' (20)
NI- (P + g + c),
= (1 - N
-- _ )[g+(p+g) w]
k~za( 1-kaa-
yieldsixequationsforthesteadystateofthesixendogenousvariablesk,(N, ~S, w,
g, and c. This definesa steady-state equilibriumgivenexogenously determined
parameters ac/a, r, 0, 0, p, and a.
A fullanalyticaltreatment of the equilibriumprovesimpossiblein our six-
equationsystem, so we resortto numericalresultsat variouspointsin thepaper.
The calibratedparameters arediscussedin Appendix4 and summarized in Table4
in thenextsection.Tables2 and 3 reportfulldetailsof thisequilibrium in which
Southernimitation and innovation existtogether.As ac increases,copyingbecomes
moredifficult,so thatSouthernresources shifttowardsinnovation, and thegrowth
rateg increases.Likewise,as the assimilationrate, ', increases,thereis a shift
towardSoutherninnovationuntil eventually, the copyingsectorvanishesfor
highenough<.
Figure1 illustratesthedomainof theequilibrium in (ac/a,i) spacewherethe
boundarybetweenimitation onlyand imitation/innovation arethosevaluesofac/a
D. CURRIE ET AL. 69
Table 2 Simulationresultsofvarying
ac
ac 0.0540 0.5500 0.5750 0.6000 0.6250 0.6500 0.6680
k 0.8847 0.8789 0.8677 0.8588 0.8510 0.8439 0.8390

C 0.8391 0.8354 0.8260 0.8162 0.8062 0.7958 0.7881
(N 0.7609 0.7347 0.6893 0.6599 0.6393 0.6245 0.6164
0.0062 0.0635 0.1692 0.2451 0.3046 0.3537 0.3845
gis 0.0161 0.0178 0.0214 0.0245 0.0273 0.0300 0.0318
c 0.0049 0.0049 0.0044 0.0035 0.0024 0.0010 0.0000
a = 0.5, a = 1.00, 3 = 1.35, p = 0.05, r, = 0.09, and 0 = 0.07.
n
Table 3 Simulationresultsof varying
K 0.0600 0.0700 0.0800 0.0900 0.1100 0.1300 0.1600
0.8380 0.8440 0.8514 0.8588 0.8722 0.8835 0.8972

t
w 0.8162 0.8162 0.8162 0.8162 0.8162 0.8162 0.8162
(N 0.7581 0.7101 0.6803 0.6599 0.6338 0.6177 0.6023
(S 0.0159 0.1249 0.1955 0.2451 0.3108 0.3528 0.3941
g 0.0163 0.0197 0.0224 0.0245 0.0278 0.0302 0.0329
c 0.0049 0.0046 0.0041 0.0035 0.0024 0.0014 0.0002
a = 0.5, a = 1.0, ac = 0.6, 3 = 1.35, p = 0.05, and 0 = 0.07.
0.35
0.30
0.25
Innovationonly
0.20 intheSouth
0.15-- Imitation wide-gap

equilibrium
and
0.10 Innovation
0.05
Imitation
only(narrow-gap)
0.00 0 a,/a
0.55 0.6 0.65 0.7 0.75 0.8
ParameterValues: a = 1; a = 0.5; 0 = 1.35; 0 = 0.07.
Fig. 1. Equilibriaforvaryingac/a and K
and r, such that = 0 in eqs (15)-(20), and the boundarybetweenimitation/

is
innovationand innovation onlycorresponds to (s = c = 0. In whatfollowswe
referto thethreephasesof development in theSouthas: (I) Southernimitation
only,(II) Southernimitation
and innovation and (III) Southern
jointly, innovation
only.Theboundarybetweenphase(I) narrow-gap andwide-gapis also shown,and
correspondsto w = a.
In phase(III) (no imitation
in theSouth),c = 0 and from(17) k = wEP.Ifthe
Southassimilates all knowledge i.e.,n ---+
instantly, o, so k-- 1,and ifinnovation
is
co'(l-o) cQa
aa
a'() <o
.....
O! 03=1
Fig.2. Changesin the South-Northwage ratiow as n increasesin phase (ii)
equallyefficient in Northand South,/3= 1, thedifferences betweenthetwoblocs

disappear: we then arriveat factor priceequalization expected.However,in
as
generalif the assimilation of international knowledgecapitalby the South is
slowerthanthatin the North(K < ,N < 00), our modelexhibitsa lowerwage
in the South even in the phase of innovationonlyin the South.At the other
extreme as n-+ 0, Southernimitation dominates(phase(I)) and Southerninnova-
tiondisappears.
The evolutionoftheSouth-North wageratiowithincreasing I as we passfrom
phase (II) (Southernimitation and innovation)to phase(III) can be foundfrom
(17) and (19). Forsimplicity,firstconsiderthecasewhenac is constant. From(19)
we see thatw remainsthe same irrespective of thevalue ofK duringphase (II).
When theboundaryin Fig. 1 is reached,the copyingsectorno longerexistsin
equilibrium,and (17) applies with c = 0. Since relativeSouthernknowledge
capital,k,increases withincreasing n,itfollowsthattherelative wageincreases too.
Our moregeneralformulation has ac = wherethisrelationship between
ac(S),
thecostofcopyingand thesizeoftheimitative sectormaybe positiveor negative.
A positiverelationship represents a diminishing returns-to-copying effectas in
Barroand Sala-i-Martin (1995), whereimitators copy those productswhichare
easiestto copyfirst,so thatthemoredifficult products copy associatedwitha
to are
A
higherac.8 negativerelationship impliesthatcopyingbecomeseasieras the
copyingsectorincreasesin size.The rationaleforthisis thatpolicingpatentsby
theNorthbecomesmoredifficult as theSoutherncopyingsectorbecomesbigger,
i.e.,therearediminishing returns to monitoring. Ifthiseffect
outweighs thedimin-
ishing returns to copying effectthen the relationship =
ac ac(s) is negative.We
can investigate theseeffects 2.
usingFig. Considering the case when dac/dJs < 0,
an increasein n encouragesinnovationin the South,decreasesthe size of the
copyingsectorand increasesac; thuswe move fromA to B, witha fallin the
relativewagein theSouth.If on theotherhandthediminishing returns effectto
copyingdominates, thenwe movedownthecurveand therelativewagerises.
8
This obviouslyraisesthe questionas to whythesame argument
does not applyto innovation(see
Stokey,1995).
D. CURRIE ET AL. 71
wageratio,o
Relative
o.83-
0.81
0.79
0.77
0.758 Imitation Innovation
0.73 / Phaseal) : Innovation
andr
0.69
0.67
0.65
0.005 0.030 0.055 0.080 0.105 0.130
Rateofassimilation,
K
Parameter Values: ac = 0.6(1 - 0.1(s); otherwiseas for Figure 1.
Fig. 3. Changesin the South-Northwage ratiow and n,increases
The resultsaresummarizedin thefollowing whichgeneralizes

proportion partof
proposition2 relating
to n:
Proposition 3 Considera transition fromsteady-stateequilibriawithinnovation

and imitationin the South (phase (II)) to innovationonlyin the South (phase
(III)) broughtaboutbyan increasein therateofNorth-South knowledge flows(an
increasein rn).Thenifdac/d~,f < 0, therelative
wagein theSouth, w, must fall;if
dac/dcs > 0 thenw must rise.
However,whenimitation disappearsin theSouthso doesthislattereffect. Then

ratesof return, in
7rb/vb, Northern and Southern innovating firmsare equalized
and therelativewageis givenbyk = wCE/ (see eq. 17withc = 0). Hencew increases
withinphase(III) as n and therefore k rises(see eq. (16)). As Southerninnovation
becomeseasierthis forcesup the Southernrelativewage. The pathsof w and
relativeconsumptionES/EN fordiffering valuesof K forthe case dac/dS < 0
are shownin Figs.3 and 4. Figure5 showsthecorresponding globalgrowthrate,
g. Note thatfor these w is
parameters, alwaysgreater than a = 0.5,so thatthereis
no wide-gapequilibriumin phase (I) of imitationonlyin the South.In factat
n= 0 and ac = 0.6 we are at the boundaryof the narrow-gapand wide-gap
equilibriain thisphase (see Fig. 1).
4. Stability
and transitional
dynamics
We nowturnto thestability ofthethreeequilibria.
Assuming thatthetradebalance
is zero,we can writethefulldynamicmodelin termsofdynamicequationsing, k,
(N, (S, and w,withg and w as jumpvariables.Appendix1 givesfulldetailsofthe
transitionaldynamics.Takingdeviationsabouttheirequilibrium
valueswe obtaina
linearizedapproximation to the dynamicsby evaluatingthe Jacobianmatrix.9
9Detailsof thelinearizedmodelare availablefromtheauthorson request.
Relative ratio
consumption
0.85
0.80
0.75
Phase(III)
0.70 Innovation
Phase(I) Phase(II) iOnly
Imitation Imitation
Only
Innovation
0.60
0.55
0.005 0.030 0.055 0.080 0.105 0.130
Rateofassimilation,
Kt
ParameterValues: as forFigure3.
Fig.4. Changesin the South-NorthconsumptionratioEs/EN as K increases
GlobalGrowth
Rate,g
0.04
0.03
0.03 i Phase
(III)
Innovation
0.02
Phase
(1) Phase
() Only
Imitation Imitation
Onl and i
0.02 - Innovation
0,.01
0.005 0.030 0.055 0.080 0.105 0.130
Rateofassimilation,
iK
ParameterValues: as forFigure3.
Fig.5. Changesin totalgrowthrateg as K increases
Numericalsimulations basedon thecalibration described in Appendix4 showthat

thesystemis saddle-path stableforphase(I) (Southernimitation only)and phase
(III) (Southerninnovationonly),and theseresults proverobustfora widerangeof
parameter valuesaboutthecentralcalibratedvalues.Table4 summarizes thedetails
of thecalibration and therangeof parameters adoptedin thesensitivity analysis,
each beingchangedkeepingotherparameters at theircentralvalues.
For phase(II), Southerninnovation and imitation,we considertwocases.First
considerthecase wheretheeffect of increasingcostsofmonitoring, < 0.
dac/ds
We findthatthesystemis saddle-path stablefortherangeofparameter valuesin
Table 4. In factthisresultholdseven fora verysmallvalue of dac/dES.In the
subsequentdynamicsimulations of phase(II) we replaceac withic - Os with
positiveand closeto zeroso thattheequilibrium resultsremainvirtuallythesame
as forTables2 and 3.
D. CURRIE ET AL. 73
Table 4 Calibrationand sensitivity

analysis
Parameter central
values range
a 0.50 0.37-0.70
0.60 0.54-0.66
ac/a
K, 0.09 0.06-0.16
p 0.05 0.01-0.09
0 1.35 1.00-1.50
The stability resultfor < 0 can be explainedas follows.Considerthe

dac/d?s
dynamicarbitragevalue for the relativewage of equation (19). In Fig. 2 its
equilibriumvalue is indicatedby pointA. Figure6 givesan exampleof the
dynamicsof the systemwith(N starting above and 5s belowtheirequilibrium
levels,(eN(0) = 1%, e(0)) -1%), is above its equilibriumlevel,the initial
ac
arbitrage levelof w is therefore at B wherethe relativewage,w, has fallen.This
makes imitationmore attractive because it raises the profitrate relativeto
innovationand the rateof copyingrises.The shareof the Southernimitation
sectortherefore risesand thatof Northerninnovationfalls.The relativewage w
graduallyrises which eventuallyleads to the share of Southerninnovation
increasingback to its equilibriumvalue. Meanwhilethe overallgrowthrate
whichdroppedinitially, also returnsto its equilibriumvalue.If instead?s starts
above its equilibriumvalue, then the South temporarily shiftsto a phase of
innovationonly.
What happens if we instead assume increasingor constant costs of
imitation? Now the relativewagew cannotfallas in the previouscase and this
equilibrating effectwhenimitationdeclinesis absent.Summarizing theseresults,
we have:
NumericalResult1 Phases (I) (Southernimitationonly) and (III) (Southern

innovationonly) are saddle-pathstablefor a wide rangeof parametervalues
about the centralcalibration.Phase (II) is saddle-pathstable if and only if
< 0, i.e.,theincreasing
costsofmonitoring
patentsdominates diminishing
dac/d?Sc
returnsto copying.
The detailsofthedynamics whensaddle-path is absent,arecomplicated

stability
and outlinedin Appendix2. However,in essencewhathappensis thattheSouth
temporarily shiftsto a phaseof imitationonly(together withproductionof pre-
viouslyimitatedand innovative Southernproducts),whichis coupledwitha drop
in therelativewage.The latterincreasesuntilthereis an incentive forbothimita-
tionand innovation to takeplace.Forthecase of ac constant,thisis exactlywhen
therelativewagehas reacheditsdynamicarbitrage (constant)value.The systemis
thereforestableas a resultofphase-switching,
ratherthanas a resultofsaddle-path
stability.
Deviation
(%)
1.5i
1.0 Ak
0.5T
0.0
-0.5
-1.0
Time
Deviation(%)
1.0
0.0
-0.5
Time
Deviation(%)
40
30
20Ac
10
-10 Ag
-20
Time
Notation:Ak is deviationfromsteadystate;Aw etc. are definedsimilarly.
Fig.6. Trajectoriesof the variables,all parameters

are at theircentralvalues.
1; s(0)= -1. Simulationsusinglinearizedformof (A.1.7)-(A.1.13)
N(0)-=
5. Subsidiesto innovationor imitation

Firstconsideran equilibrium withhighr,whenthereis no imitation in theSouth
(phase (III)). Suppose thatthe Northern governments finance a fraction0 N of all
Northern research expensesbya lump-sumtaxon residents; thislowerstheprivate
costofinvention to (1 -_qN)awN/KN. Thisin turnraisestheprofit/valuation ratio
which,assumingthe no-arbitrage condition,is equal to g + p. The subsidyto
innovationraisesthereturnfrominnovation, butleavesthereturnto production
unchanged, and this induces a shift
in labourresources fromproduction to inno-
vation.The positivespillovereffects fromknowledge capitalraisethereturnfrom
innovation in theSouthas well,so thatthereis a further
shiftin thesamedirection.
D. CURRIE ET AL. 75
Eq. (21b)
0N increases
0
Eq. (21a)
g1
icae
Fig.7. Effects
of subsidies in phase(III)
on growth
The combined
effectis to raisethesteady-state
globalgrowthrate.A similar
applies
argument to a subsidyqs to innovation
in the Southfinancedby a
tax
lump-sum on Southern residents.
we can establishthe increasein g by writingthe equilibrium
Analytically
conditionsas
O=-aN [g+ p + g)(l-1 N)] (21 a)
k 1
la(
-
N) [g + g)(1 - ~O)] (21 b)
(p
a
0=a(1 +l
Equations (21a) and (21b) follow from (20) by putting1 - N and
1- E - i-
= S = 0 in phase (III). It is now easy to show that in (g, (N) space,
thefirst
oftheseequationsslopesdownand shifts to therightwithincreasing 0qN;a
littlemoreeffort
showsthatthesecondequationslopesup and also shiftsto the
rightwithincreasing
Os (see Fig.7).
We can summarizethisas follows:
4 In an equilibrium
Proposition withno Southernimitation(phase(III)), a subsidy
to eitherNorthern or Southerninnovation
raisesthesteady-state
growthrate.
Now considerthe oppositeextremeof low n, wherethereis no innovation
activityin theSouth(phase (I)). G&H considera specialcase of phase(I) where
thereare no international spilloversi.e., ,N = ,S = 0, (although,fromeq. 7, ,N
plays no role if the Southdoes not innovate).Our treatment of thisphase gen-
eralizesthatofG&H to thecaseKs =- > 0; in factourresultsdo notqualitatively
differ.
A subsidyto Northern innovation increases theshareofvarietiesproducedin the
North;a subsidyto Southerncopying, has theoppositeeffect by increasingthe
qcs,
rateoftransfer ofproductionto theSouth.Thereare threeeffects to consider:on
the Northerncost of a blueprint,on Northernoperatingprofits,and on the
effectivecostof capital.Iftherateof copyingincreasesthenthecostof Northern

capitalincreases and thiswilltendto reduceinnovative activityin theNorthand
hencethe steady-state worldgrowthrate.However,the destruction of Northern
varietiesreleaseslabourand drivesdowntheNorthern wage.Thisreducesthecost
ofa newblueprint whichwilltendto increaseinnovativeactivity.Furthermore in a
wide-gapequilibrium a reductionin the Northernwage will increase the relative
demandforNorthern varieties
and increaseoperatingprofits.Ifthepositivecom-
binedeffect on growthofreducing thecostofa bluepintand increasing operating
profitsexceedsthenegativeeffect froman increasein thecostof capital,thena
subsidyto Southerncopyingwill increaseworldgrowth;indeedforthe chosen
specificationof themodelthisis whathappensin thewide-gapequilibrium. In a
narrow-gap equilibrium therelativedemand for Northern varietiesis independent
oftherelative wageand operating areunchanged
profits ifthelatterchanges.This
reducesthe positiveeffecton growthand forthe specification of the model,a
subsidyto theSouthis nowneutralin itsimpacton growth. Bycontrast a subsidy
to Northerninnovationraisesgrowthin both a wide-gapequilibriumand a
narrow-gap equilibrium.
We can establishtheseresultsanalytically forthe narrow-gap case. The term
-
(1 O/)w/ -
(1 w) can be eliminated fromtheequationsing, c, N,and k,so that
thelabourmarketclearingconditionsreduceto
S= ag + (1 - )( pN +g) (22 a)
1-a
-
(1 -
N
o+)
[g
kI-a
+
a-(22b)
1-E
(,_ON)p +
(N (22 b)
Usingtheexpressionfork,we can showas beforethatin (g,eN) space,(22a) slopes

downand (22b) is upwardsloping,and theybothshiftto therightwithincreasing
0/N;henceg increases
withON. It also followsthatwelfare
willbe unaffectedbythe
imitation
subsidy,sinceit depends on the world which
priceindex, is independent
of theSouthernwage.
For thewide-gapequilibrium, thelaboursupplyequationsreduceto
S= ag + a (1 - N)(g + (23 a)
poN)
1-a
S= a
(1-N)[g+[ a (p + g)(1 - ~ )]. (23b)
k 1-
a
and againit is straightforward
to showthatg increaseswithON and Os.
We summarizetheseresultsas:
Proposition5 In an equilibriumwithimitationonlyin the South (phase (I)), a

subsidyto Southernimitationraisessteady-state
growthin a wide-gapequilibrium,
but leaves growthunchangedin a narrow-gapequilibrium.The effectof a
subsidyto Northern innovationraisesgrowthin botha narrow-gap and a wide-
gap equilibrium.
D. CURRIE ET AL. 77
(a) Subsidizingthe North
so- 2.5
60
1.5
1
50
200.5 2
-i 0 i
0.-----
0 20 11 2 3 3( : 4 20 11 2
2 (%)
3 4 5
(b) SubsidizingSoutherninnovators
70 - 3.5
2.5
40
20 0
1 i I
0 2 4 8 10 0 2 4 6 8 10
(c)Subsidizing
Southern
imitators
20 0.5
40
00.5
0 2 4 6 8
(b)
~r"
10 0 2 4
0(9S
6 8 10
Fig.8. Effects
of subsidieson steady-state
productsshares, 'N, and the rates
of growthg and copyingc forphase (II). ON is the fractionofiS,
NorthernR&D
innovationcosts financedby a subsidy.4s, qOSsimilarlydefinedforSouthern
innovationand copyingrespectively
Considernow an equilibrium withbothinnovation and imitation in theSouth

(phase (II)). Appendix 3 setsout the model in thiscase with subsidiesto innova-
tion and imitation.Analyticalresultsare impossibleto obtain,so we present
numerical results.
The resultsofsubsidizing theNorthern innovators,theSouthern
innovators, and Southernimitators are presented in Fig. 8. In thissituationany-
thingwhichinducesmoreimitation represents a wasteofresources and is likelyto
lowerglobalknowledgecapitaland welfare.A subsidyto Northerninnovation
raisesthereturnto innovationas beforeand thereby raisestherelativewagerate
in theNorth.However,thisraisesthereturnto imitation in theSouthand induces
a shiftin labourresourcesfrominnovation to imitation in theSouth.The overall
effectis seemingly perversein thatthe growthratedrops,althoughthe shareof
Northern innovationsand Southern imitations increases at theexpenseofSouthern
A subsidyto imitationin theSouthhas similareffects.

innovations. Againoverall
growth decreasesand imitation increaseswhilethe shareof Northerninnovations
and Southernimitationsincreases.However,benefits arederivedfroma subsidyto
Southerninnovation. In thiscase thereis nothingwhichinducesimitation in the
South;indeedtheimitationratedeclines.Overallgrowthincreasesin bothSouth
and North(becauseofthespillovereffects), and thebehaviouris similarto those
seenin theequilibriumdiscussedabovewithno imitation in theSouth.Indeedfor
highsubsidiesto Southerninnovation,
sufficiently imitationcompletelyvanishes.
Theseresultsare summarized as:
Numerical Result2 In an equilibriumwithimitation and innovationin theSouth
(phase (II)) a subsidyto imitationin the Southor innovationin theNorthcan
lowerthe steady-state growthrate.A subsidyto Southerninnovation, however,
raisesthesteady-stategrowth rateandcanleadto a transition
to phase(III) withno
imitationin theSouth.
We bringtheresultsofthissectiontogether inTable5. Thecontrasting impactof
subsidiesto the South is particularly Subsidies
interesting. to Southern copying
improveworldgrowthonlyin thewide-gapphase (I) corresponding to a large
North-Southwage differential. As we proceedto a narrow--gap phase (I) the
growthimprovement disappears,whilst in phase (II) this particularsubsidy
actuallylowersworld growth.Two furtherpointsworthmakingare first,a
relaxationof intellectual
propertyrights(IPR), whichlowersthe relativecost of
copyingin theSouth(ac), willhavea similareffecton worldgrowth as a subsidyto
Southerncopying(butatlesscostto theSouth).It followsthatstrengthening IPR is
notalwaysthebestpolicy,certainly fortheSouth,butevenin thewide-gapphase
(I) fortheNorthas well.10Second,one mightexpectthelong-term growtheffects
to dominatewelfareso that 'growth-enhancing' approximately amounts to
'welfare-enhancing'.However,to investigatethis requiresa rigorouswelfare
analysis,to whichwe now turn.
6. Welfareanalysis
Welfareis definedforeachbloc byexpression
(A.1.1) in Appendix1, so thatfrom
(A.1.2) and the pricingbehaviourpN = wN/c, pS = ws/a and pS = wN we obtain
-
Ub(O)- e-pt logEb + log[nN(pN)'- + ni(w~wp)l + nc(apN) 1] dt
(24)
Note that(24) appliesto all phasesin theSouth:nS= 0 in phase(I), nS,c > 0 in
phase(II), and
n_ = c = 0 in phase(III). Sincephase(II) is moregeneralthanthe
10
Helpman(1993)studies
thisissuein a North-South
modelwithimitation onlyin theSouth.His
modelis somewhatsimplerthanours,andthatinG&H,inassuming costless
imitationandmarginal
costpricing
intheSouth.Ourwelfare belowclosely
analysis follows
Helpman.
D. CURRIE ETAL. 79
Table 5 Effect growth(g) ofsubsidiesto:copying

on steady-state
in theSouth(qs); innovation
in theSouth and innovation
in theNorth(0N) (si);
Phase c ~S oN
(I) wide-gap increases N/A increases

(I) narrow-gap unchanged N/A increases
(II) decreases increases decreases
(III) N/A increases increases
Notation:phase(I)-imitationonlyin theSouth;phase(II)-imitationand inno-

vationin theSouth;phase(III)-innovation onlyin theSouth.
otherphases,we examinethenumerical detailsofthewelfare analysisforthisphase

firstof all,and thoseof phases(I) and (III) briefly at theend of thissection.
Again analysis is intractableso we use numerical methods.In the trajectories
shownin Fig.9 we assumethatthesystem startsin equilibrium, and a permanent
is
subsidy applied which eventually moves the system to itsnew equilibrium.Then
(24) gives the intertemporal social welfare (i.e., the utilityof the representative
consumer)alongthetransition path.As one mightexpect,subsidiesto Southern
copyingreducewelfareforbothNorthand Southowingto the reductionof the
innovationsector.Conversely, subsidiesto Southerninnovationraisewelfareof
both Northand Southowingto the reductionof the imitationsector.An even
stronger resultemerges. SupposethattheNorthis willingto payforsomeor all of
thissubsidyto Southerninnovation, achievedbya freetransfer ofgoodsfromthe
Northto theSouth.For all theparameter combinations we havetried,thereis a
welfare gainforbothblocs,comparedwithno subsidy, no matter howmuchofthis
subsidy is paid for by the North. For our set of parameters, the trade-offofwelfare
gains for various different transfersfrom North to South to support subsidyis
this
depictedby the curve in Fig. 10. Finally we turn to the effectsof a subsidyto
Northern innovation. As we haveseen,long-rungrowth decreases,butthewelfare
effectsover different parametercombinations are equivocal;sometimeswelfare
increases, sometimesit decreases.
To understand theseresults,we firstdecompose(24) by removinga factorn
fromthesecondlog term.Integrating thelog(n) termbypartsyieldsthefollowing
expression
log
Ub(0) n(O) + +
e-Pt{ P(E - 1)g log
Eb
1)
p(E-
1 log[ + (1 -
e--1 (pN)l + (pN)l i)(N)- dt (25)
Now recallthatwe have assumedfinancialautarkyin each bloc and therefore

balancedtrade.Hence expenditure
in each bloc equals thevalue of output;i.e.,
(a) Subsidizingthe North

Deviation
(%)
15 0.13
0.12
10-
0.11
5 Ac 0.10
0.09
Ag0.08
-5 0.07
(b) SubsidizingSoutherninnovators
Deviation
(%)
10 0.10
S----- 0.05
-5
-5 Ac
-10 0.00
-15 -0.05
-20
-25 -0.10
(c) SubsidizingSouthernimitators
Deviation
(%)
15 0.06
10 -0.04
5 &c 0.02
0.00.
0 / -0.02
-5 - -0.04
Notation:Axt= (x, - x)/x wherex is the steadystatevalue.
of thedeviationsAgtand Act withdifferent

Fig.9. Trajectories subsidies(all at
5%) over a periodof fiveyears phase (II). Magnifiedgraphson right-hand
for
side forsmall deviations.
S= p"n"x" and ES = pnx +pnS x = wpNnxs + ap nSx. Hence using(8)

and (12), (25) becomes
UN(0) logn(0)+ e-pt 9( + log[O- a(g- (SgS)]

-
+ E -1log [(N ljdt (26)
l-
+ %SW + (1 N j ] dt (26)
D. CURRIE ET AL. 81
UN" 0.56)
O(0.38,
(0.45,0.49)
*,
0 Us
(-0.15.-0.24)
s, 0, .
(0.09,-0.15)
No paymentof subsidyby North;

q:
:O': fullpaymentof subsidyby North.
subsidies(all at 5%) forphase (II)
Fig. 10. Welfaregainsfromdifferent
log e-Pt
US(o) = p(E -n(0)
1) g
p(-1) + o 0 k (g
_ ii _ gN) aoSgS
k
S[ log[N + S- + (1 -N _ )C-
+ log i- + (1- dt (27)

for the North and the South respectively. Notice that in phase (III),
-
S = /n = (NgN + (I
g + S = 1, so thatwhentheSouthcatchesup, f 1,
--+00,k-+ 1, and SigjS, UN(O).
US(O)---
We can now interpret thisdecomposition as consistingoffoureffects. The first
termis a leveleffect; in a growthcontextthe intertemporal is
utility constantly
increasingand dependson theinitialstaten(0). The secondtermis a growth effect
whichbecomesverylarge,fora givengrowthrate,as thediscountratep -- 0. The
thirdterm,a consumption effect, is an increasing functionof the proportionof
labourallocatedto the productionof consumption goods anytime.(Equiva-
at
lentlythisterm is a decreasing function of thesavings investment
or rate).The final
termembodiesan inter-bloc allocationand termsoftradeeffect."It expresses the
welfaregainsto tradeand we referto it subsequently simplyas thetradeeffect.
In Table6 we showthegrowth, consumption and tradecontributions to welfare
forboth Northand South forthe threesubsidies,in all threephases (I-III).
Considerfirstphase (II): forthefirsttwosubsidies,Os and 5s,thegrowtheffects
consistentlydominatethe othertwo effects. For qs, savingsrise forthe South
because of the increasein R&D, but tradeimprovesbecause of the shiftfrom
limitpricingto mark-uppricing;conversely thereis a decreasein Northern savings
" For S = 0, fortheNorththisequals~" + W1-EJ,whilefortheSouthitis s + W,-'N, and theseare

both 1 whenw = 1.
Table 6 Northand Southwelfaregainsforall subsidies
Growth Consumption Trade Total

North South North South North South
Phase(I): narrow-gap
ON = 0.05 0.57 -0.53 -0.27 0.05 0.05 0.09 0.35
Phase(II)
Os = 0.05 0.67 0.02 -0.64 -0.13 0.35 0.56 0.38
S= 0.05 -0.24 -0.02 0.15 0.02 -0.12 -0.24 -0.15
ON = 0.05 0.23 -0.52 0.10 0.14 -0.24 -0.15 0.09
Phase(III)
= 0.05 0.34 -0.03 -0.46 -0.18 0.25 0.13 0.13
ON = 0.05 0.47 -0.48 -0.02 0.19 -0.37 0.18 0.08
becauseof the decreasein copyingand the consequentreductionin the cost of

capital,althoughof coursethereis a worsening in trade.For OS theconsumption
and tradeeffects are oppositeto this.For ON, theeffects are similarin essenceto
in
thosedue to an increase Os; thisis becausethesubsidyto Northern innovation
increasestheshareofNorthern innovative goods,thereby leadingto an increasein
copyingat the expenseof Southerninnovation.Note thatthe growtheffecton
welfareforON is positivedespitethe factthatthe effect on long-rungrowthis
negative; thisis because after a sharp initialreduction in the Southernwagewhich
the in
anticipates surge copying, there is a sharp decrease in growth;then,as the
Northerninnovationsectorgradually movesto itslong-runshareof themarket,
thereis a verylongperiodofincreasedgrowth whichprecedestheeventualdecline
to below its equilibriumwithoutsubsidies(see Fig. 9). The middleperiodof
increasedgrowthis the dominanttermin the growtheffect, whichensuresthat
it is positive.The tradeeffectis a beneficialone forthe Northbecauseof the
increasein the copyingsectorand the subsequenttransfer of productionto the
South wherethe wage and priceare lower.For some parametercombinations
(althoughnot thoseof Table 6) the growthand tradeeffects slightlyoutweigh
theconsumption effect.
Table 6 also includestheeffects of subsidiesforthephase (I) narrow-gap and
S
phase(III) cases.We omit fortheformer since,as discussedin Section5, ithas
no realeffects. For ON in phase (I), growthincreasesand therefore consumption
decreasesin bothblocsas resources shiftintoinnovation and imitation; thetrade
effect is thesame forbothblocs sincethereis no pricechangeas a resultof the
subsidy,and is positivebecausea greater proportion ofgoodsis nowmanufactured
in theSouthwherecostsarelower.In phase(III), a subsidyto innovation in either
bloc increasesoverallgrowth, and thespillover ofknowledge capitalinducesmore
innovationat theexpenseoflowerconsumption in theotherbloc;fora Northern
subsidy,the effect on theNorthof a decreasein the shareof Southerngoods is
dominatedby theeffect of its improvedtermsof trade,so thatits tradeeffect is
D. CURRIE ET AL. 83
whereas
positive, theoppositeis trueforthetradeeffect
in theSouth,'2
andthis
fora Southern
holdsanalogously subsidy.
7. Conclusions
We havepresented a modelofimitation andinnovation whichhasthefeature of
catchingup whichis mostclearly relevanttothePacific Rimeconomies. We have
shownthatequilibria including innovation and/orimitation dependon cross-
country knowledge assimilation effects
and the ease of imitation.
Wehaveanalysed theeffectsofvarious different types ofsubsidy andsomeclear
globalpolicyimplications emerge. whether
First, subsidies to R&D in boththe
NorthandtheSouth,financed bytheregion concerned, increase welfaredepends
ontheSouthern
crucially phaseofdevelopment. In phase(III),withinnovation in
bothregions, subsidies are unambiguously beneficial and increase welfare and
growth, Northand South.In phase(I) wheretheSouthonlycopies,thesame
resultis obtained.However, in phase(II) thesituation is morecomplicated.
Onlya subsidy to Southern innovation increases welfare in bothblocs.Subsidies
eitherto Northern innovation or to Southern copying increase thelatterand
discourage Southern innovation. Thisresults in a welfare dropforone or both
regions.
Thesecondresult is thatin phase(II) subsidies to Southern innovation areso
totheNorth
beneficial thatevenwhenthey arefinanced by thatregion the result is
Pareto-improving. GiventhattheSouthis in reality a mixture of countries in
different
phasesofdevelopment ourresults suggest thatsupport forR&D viewed
froma globalperspective callsforcarefully designed differentiated policieswhich
takeintoaccountdifferent North-South trading Given
relationships. theinter-
nationalspillovers,the coordination of these policiesmaydeliver significant effi-
ciencygains and this one
suggests important area for future research.
becauseourmodelisa fullemployment
Finally, one,ourwelfare analysisignores
transitionalunemployment effects from
arising thereplacement ofimitation with
innovation intheSouth,andthecontinuous transfer oflabourto newvarieties in
boththeNorthandtheSouth.Theunemployment aspectofNorth-South tradeis
addressed in Wood (1994)andRowthorn (1995),butthesestudiesignore long-
termgrowth effects.
Thedevelopment ofNorth-South modelstoincorporate both
endogenous and
growth unemployment, for on
building, example, Aghionand
Howitt(1994),is another direction forfuture research.
Acknowledgements
Thispaperis produced
as partoftheESRCGlobalEconomic
Institutions Grant
Initiative,
No.L120251005.Wearegratefultoparticipants
atGEIworkshops,
Jaume Ventura andother
12The
previous
footnote
canbe usedtoclarify
thealgebra.
participantsat the1996AEAAnnualMeetingin San Francisco, and participants

at seminars
given at Exeter London
University, BusinessSchool,London Middlesex
GuildhallUniversity,
University,and the1997Far EasternMeetingof Econometric in
Society HongKong.We are
also grateful
forfeedback fromtheESRC sponsoredInternational EconomicsStudyGroupat
whoseAnnualConference, 1996,an earlierversionof thepaperwas given.Helpfulcom-
mentsin particular werereceivedfromJohnBlack,MansoobMurshed,PeterSinclair,and
AdrianWood at thatconference. we havebenefited
Finally, fromdiscussionswithAndrew
Sentanceat variousstagesof theresearch.The usual disclaimerapplies.
References
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Appendix1
1. Transitional
Dynamics
In thisAppendix,we providethedetailsof thedynamicsof themodel.Withlittleloss of
we assumeLS = LN = 1.
generality,
1.1 The model

We definetheintertemporal ofbloc b as
preferences
Ub(t) = e-P(-t) log Db(r) dT

(A.I.1)
wherep is thesubjective
discountrate,and Db(r) takesthefollowing
form
Db [{_
di"j
It is well-known thatcurrent periodmaximization
of Db overthevarietiesgivennominal
expenditure Eb n=
o pjxjdj yields(A.1.2)
Eb
maxDb = (A.1.2)
op- dj)1/(1-E)
(S0
Eppe
x=
pj.E (A.1.3)
dJ
The budgetconstraintsfortheNorthand Southare givenby
AN = rNAN+ WN_ EN AN = nNvN
As = rSAS+ ws - Es As = ncS + nvY (A.1.4)
whereAbis thetotalwealth.Maximizing (A.1.1)subjectto (A.1.2)and (A.1.4)and imposing
theusual transversality
conditionsgives
Eb= rb
b- p; for b = N, S (A.1.5)
1.2 Transitional
dynamics
We choosethenormalizationwN= 1 and assumedbalancedtrade.Thenexpenditure
equals
outputin each bloc,i.e.,
EN = p nNxN =1 n xN
ESm
=po S
+s psnxt =inix a+s
nx (A.1.6)
of themodelas setout in (1)-(12) aboveleadsto'13
Algebraicmanipulation
13
Fulldetailsare availablefromtheauthors.
0-ag
+a<ggi
S
0- (
63) k _SgS- - (A.1.7)
-ag+a+ +
a( (1-- w)a-E
(1 k
ac + ) w)a -_
=0
(0- ag+ dgi) (A.1.8)
(1 - a) - ag +a gis
d(O-g +a - ag
) (0 - agS)
dt
= -
ga gpS+ [
- - -
(g _gS (NgN) (A.1.9)
k= - kg= (g +
a)(1 - k) - g (A.1.10)
*N Nh
-N n nn NgN _ Ng (A.1.11)
=
is Sgi (A.1.12)
.g
c k+ a W-Ek (1 - a) 0 - ag+
aqsgis
k aaw N = aa JN
1(g- - NgN)
-N
(1 - - + -aS l-gN - -E
S wl-?S + al-E(1
-
_ iS)
(A.1.13)
(A.1.7) and linearidentities
(A.1.8) represent for(NgNand in termsof thefiveother
iSgs by (A.1.9)-(A.1.13).
variables:g, k,(N, and w. The dynamicsoftheseare represented
iS,
Appendix2
1. Dynamicsof model when phase (II) is not saddle-path
stable
Herewe givean outlineofthestablebehaviourofthesystem whenac is constant.The latter
corresponds to a constantarbitragevalueofw (call itW-)whentheSouthbothimitatesand
innovates.Firstly we observethatwithw constant, therearethreepre-determined variables,
and onejumpvariable, g. The systemhastwounstableeigenvalues attheequilibrium, so that
we wouldtherefore describeit as unstable.Note,however, thatthereis onlyone less stable
eigenvaluethanthenumberof predetermined variables;thusthereexistsa uniqueplanein
(k,(N, (S) space,suchthatiftheinitialvaluesofk,eN, iS lie on thatplaneand closeto the
equilibrium, thenthesystem willconverge to theequilibrium. We shalldefinetheregionto
one side of thisplane as the Southernimitationonlyregion,and the otherside as the
Southerninnovationonlyregion.
Supposethattheinitialvalueslie in theSouthernimitation onlyregion.The dynamics in
thisregionare different fromthoseon the plane becausethereis no arbitragerelation
betweencopyingand innovationin the Southso thatw in particular has dynamics(see
(A.1.13)). In addition,from(A.1.7) we see thatwithgS = 0, thedependenceofg and (NgN
on the othervariableschanges,so that(A.1.10)-(A.1.12)are different. Thereis an initial
D. CURRIEETAL. 87
jumpinwtobelowW,andalsoa jumping. Thesejumpsareconsistent withthevariables

k,
(N, ande meeting thestableplaneexactlywhenw hasrisentoW,andwithg attaining a
valuewhichallowsgNtobe continuous duringthetransition
from Southern imitation
only
to Southern
innovationandimitation.
Analogousbehaviourtakes placeintheSoutherninnovation
onlyregion,wherewinitially
jumps,andthengraduallyfallstoW-.Someadditional shows
analysis that the
vectorofvalues
oftherighthandsidesof(A.1.10)-(A.1.12)forthephasesofSouthern imitation
onlyand
Southerninnovationonlylieondifferent
sidesofthestable
plane.Thiscompletes
theoutline
proofofstability.
3
Appendix
1. Subsidies
In thisAppendix,
we present
thechanges
to themodelwhensubsidies
are granted
by
thegovernment to Northern Southern
innovation, innovation
and Southernimitation
respectively.
1.1 Subsidy
to Northern
innovation
LetONbe therateofsubsidy
government totheNorthern
ganted thus
innovators,
KNvN = ( - ON)wN
a
thefirst
replaces in (9). Thisleadsto changes
equation to eqs (17) and(20)
P+g - N)
kw-e(1 (17)
p+g+c f
p+g+c=
1-a
a[ - (1- )ag]a?NN)
(1O-
( N
1
(20')
1.2 Subsidyto Southerninnovation

ifwe assumetherateof subsidyto Southerninnovators
Similarly, is Os, thenwe have
K
Kss
v-= (1- 0)wS
ap
whichreplacesthefirstequationin (9). Thisleadsto changesto eqs (17), (19) and (20)
p+ g kw-
p+g+c -(1- qs) (17")
ac 1 a'C(1-a)
a -( s a 1--wc(19")
Sw l aa 10
0= +
k (-)(I) 1-w k g+(p+g) I) (20
1N ) 1- a' (1-
- -(P+-) I--
1.3 Subsidy to Southernimitation:narrow-gapcase
ifweassumegovernment
Finally, is subsidizing
Southern
imitation
attherateof0s, then
Ss= (1 - qS)wS
acf
thefirst
replaces in (9). Thisleadsto change
equation in eqs (19) and(20)
-
ac a'(1 a)
(1- ) a w /1-W) (19"')
a =- w
k 1+)
S-
0 acO(1-N _-)[g+(p+g)
(14)] (20"')
1.4 Subsidy to Southernimitation:wide-gap case

Phase(I) (narrow-gap)
follows (s = 0 andsuppressing
byputting (17). Forthewide-gap
case,first theno-subsidy
consider Then(18) is replaced
steady-state. with
- P+A- (18')
a-
acP p+ g + c
and theSouthernlabourmarketequilibriumin (20)
a a
(-N) +(P+g) (1 ) (20")
Otherwiseput(s = 0 andsuppress
(17) asbefore.
Subsidies
arethenincorporated
as forthe
narrow-gap case.
Phase(III) follows (s = 1 - sN- s = 0 andsuppressing
byputting (18).
Appendix4
1.1 Calibration
Our numericalsimulationsrequireparameter valuesfora, a, 3, p, and 0 forFig.1.
2
Figures and 3 in
require, addition,
ac and theremaining simulations also require
K.
Firstwe normalizea at unityand choosea discountratep = 0.05. A plausible
mid-rangeestimateforthe elasticity of substitutionis around2, so we choose
a = 0.5 (see Krugman,1991). For theparameters 0 and 0 we experimented with
combinations so as to givea South-North consumption ratioof 0.6 at thebegin-
ningof phase (II) in Fig.4. This roughlycorresponds to GDP percapitaat PPP
observedforSouth Korea and Taiwanrelativeto thatin the UK. We obtained
/ = 1.35 and 0 = 0.07. Finallyour centralvalueofK was chosento locatea point
abouthalfwaybetweentheimitation-only and innovation onlyphasesintheSouth
at ac = 0.6. This gave -= 0.09.

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Phases of Imitation and Innovation in a North-South Endogenous Growth Model

Phasesof imitationand innovationin a

By David Currie*,Paul Levinet,JosephPearlmanjand Michael

A North-Southendogenousgrowthmodelis developedto examinethreephasesof

See Chui et al. (1996) forfurther

theother. Figure1 inSection 3 belowsummarizes thisdependency. Theparameter

Xi= nEpI j [0,n] (1)

s = 7rs (1 - a)p~xS (3)

possibleco-existence ofinnovation and imitation in theSouth.The generalidea is

4 The generalapproachto modelling knowledge international is takenfromRivera-Batiz

0 < KN, nS < oc, is not immediate.In particularthereare gradualspillovers from

6 With thisassumptioncatchingup by the South occursas but overtaking

The modelsetout above characterizes thethreephasesof development we are

The moregeneralcase KS = KS(nN, ns) is briefly

Now letus introducesomemorenotation.Letw = wS/wNbe theSouth-North

k 0.8847 0.8789 0.8677 0.8588 0.8510 0.8439 0.8390

a = 0.5, a = 1.00, 3 = 1.35, p = 0.05, r, = 0.09, and 0 = 0.07.

0.8380 0.8440 0.8514 0.8588 0.8722 0.8835 0.8972

a = 0.5, a = 1.0, ac = 0.6, 3 = 1.35, p = 0.05, and 0 = 0.07.

0.15-- Imitation wide-gap

ParameterValues: a = 1; a = 0.5; 0 = 1.35; 0 = 0.07.

Fig. 1. Equilibriaforvaryingac/a and K

and r, such that = 0 in eqs (15)-(20), and the boundarybetweenimitation/

Fig.2. Changesin the South-Northwage ratiow as n increasesin phase (ii)

equallyefficient in Northand South,/3= 1, thedifferences betweenthetwoblocs

Parameter Values: ac = 0.6(1 - 0.1(s); otherwiseas for Figure 1.

Fig. 3. Changesin the South-Northwage ratiow and n,increases

The resultsaresummarizedin thefollowing whichgeneralizes

Proposition 3 Considera transition fromsteady-stateequilibriawithinnovation

However,whenimitation disappearsin theSouthso doesthislattereffect. Then

9Detailsof thelinearizedmodelare availablefromtheauthorson request.

Fig.4. Changesin the South-NorthconsumptionratioEs/EN as K increases

Fig.5. Changesin totalgrowthrateg as K increases

Numericalsimulations basedon thecalibration described in Appendix4 showthat

Table 4 Calibrationand sensitivity

The stability resultfor < 0 can be explainedas follows.Considerthe

NumericalResult1 Phases (I) (Southernimitationonly) and (III) (Southern

The detailsofthedynamics whensaddle-path is absent,arecomplicated

Notation:Ak is deviationfromsteadystate;Aw etc. are definedsimilarly.

Fig.6. Trajectoriesof the variables,all parameters

5. Subsidiesto innovationor imitation

O=-aN [g+ p + g)(l-1 N)] (21 a)

effectivecostof capital.Iftherateof copyingincreasesthenthecostof Northern

Usingtheexpressionfork,we can showas beforethatin (g,eN) space,(22a) slopes

Proposition5 In an equilibriumwithimitationonlyin the South (phase (I)), a

(a) Subsidizingthe North

Considernow an equilibrium withbothinnovation and imitation in theSouth

A subsidyto imitationin theSouthhas similareffects.

Table 5 Effect growth(g) ofsubsidiesto:copying

(I) wide-gap increases N/A increases

Notation:phase(I)-imitationonlyin theSouth;phase(II)-imitationand inno-

otherphases,we examinethenumerical detailsofthewelfare analysisforthisphase

Now recallthatwe have assumedfinancialautarkyin each bloc and therefore

(a) Subsidizingthe North

Notation:Axt= (x, - x)/x wherex is the steadystatevalue.

of thedeviationsAgtand Act withdifferent

S= p"n"x" and ES = pnx +pnS x = wpNnxs + ap nSx. Hence using(8)

UN(0) logn(0)+ e-pt 9( + log[O- a(g- (SgS)]

No paymentof subsidyby North;

+ log i- + (1- dt (27)

" For S = 0, fortheNorththisequals~" + W1-EJ,whilefortheSouthitis s + W,-'N, and theseare

Table 6 Northand Southwelfaregainsforall subsidies

Growth Consumption Trade Total

becauseof the decreasein copyingand the consequentreductionin the cost of