Contents lists available at ScienceDirect Economic Modelling journal homepage: www.elsevier.com/locate/econmod Tariff induced licensing contracts, consumers’ surplus and welfare Abhishek Kabiraj, Tarun Kabiraj ⁎ Indian Statistical Institute ARTICLE INFO JEL classifications: D43 F13 L13 Keywords: Two-part tariff contracts Fee licensing Royalty licensing Consumers’ surplus Welfare Tariff protection ABSTRACT We construct a duopolistic trade model with technology transfer and consider two-part tariff licensing contracts. We show that a tariff on foreign products can influence the licensing strategy of the foreign firm. There is a trade-off between a tariff and a royalty license in affecting the product price. We show in particular that a tariff can be chosen so as to induce fee licensing and maximize both consumers’ surplus and domestic welfare. This resolves the so-called conflict between these two objectives in respect of the choice of a tariff. The paper provides a number of testable hypothesis. 1. Introduction Many countries, particularly the developing ones, after following a policy of protectionism for a long time, have switched to the policy of liberalization and opening up. The basic thrust of this liberalization policy is to reduce trade restrictions and promote free competition. The World Trade Organization (WTO), the key international organization in world trade, has been entrusted with the task of framing rules and regulations and implementing a free and smooth movement of goods and services between countries. The WTO is insisting throughout the period on lowering the tariff rates to the minimum. Still many countries, both WTO members and non-members, are observed to continue with high tariffs, 1 and this is happening in spite of an internal pressure to lower tariffs to favor the consumers who were the worst sufferers in the regime of protection and trade restriction. Therefore, it calls for a more careful analysis. Perhaps tariff as an instrument cannot be ignored in the process of development even in a period of liberal- ization. Under liberalization as tariffs on foreign products are lowered, the foreign firms find it easy to enter the domestic market. This generally increases competition in the domestic market and benefits the con- sumers. One may then tend to believe that consumers’ welfare would be maximum if tariffs are reduced to zero. A positive tariff, on the other hand, benefits the local firms; the domestic government also collects tariff revenue on foreign products. To the extent consumers suffer under tariff protection, the local government may perhaps justify positive tariffs stating that it seeks to maximize domestic welfare. The existing literature generally accepts this conflict to exist between welfare maximization and loss of consumers’ surplus. Hence one purpose of the present paper is to examine whether it is possible to design a tariff policy that will target to maximize both social and consumers’ welfare. The related question is: Does a tariff benefit the consumers? A government pursuing a tariff protection generally raises its domestic welfare, but that is often at the cost of a higher product price. So the consumers as a class become adversely affected. To a political party in power seeking to win an election, such a policy may not be desirable. After all, consumers form the largest electorate group; so consumers’ welfare cannot be ignored. One important feature of the present paper is that while analyzing tariff protection, we introduce technology licensing. When a country follows a policy of prohibitive tariff, the foreign firm cannot directly enter the domestic market with goods. Under this situation it transfers its superior technology to a domestic firm and extracts rent from the domestic market by charging an appropriate price for the transferred technology. 2 Under non-prohibitive tariffs, on the other hand, not only can the foreign firm enter the domestic market directly, but at the same time it has the option to transfer its superior technology to its product market competitor. Technology transfer from an advanced foreign firm to a technologically backward domestic firm is common and well- documented. A recent survey conducted by the OECD in collaboration http://dx.doi.org/10.1016/j.econmod.2016.11.001 Received 6 May 2016; Received in revised form 2 November 2016; Accepted 3 November 2016 ⁎ Correspondence to: Economic Research Unit, Indian Statistical Institute, 203 B. T. Road, Kolkata 700108, India. E-mail addresses: kabiraj27abhishek@gmail.com (A. Kabiraj), tarunkabiraj@hotmail.com (T. Kabiraj). 1 This is evident from the statistics and information published in the World Tariff Profiles 2015 (see the website www.wto.org/statistics). 2 This was actually the experience in India before liberalization (see, for instance, Alam (1985)). Economic Modelling 60 (2017) 439–447 0264-9993/ © 2016 Elsevier B.V. All rights reserved. Available online 14 November 2016 crossmark