Two risk-neutral firms A and B in each industry game:

i 0,1 play the following sequential

1) Either A or B come up with an invention (i.e., wins the invention race). The reason
for this is that when t, at least one innovation takes place with probability one no matter how small the arrival rate of innovations is in the specific industry. This is true in for the R&D technology of any endogenous growth model: in the model of innovations by incumbents we have that the probability of one incremental innovation in time interval t is equal to zv , t t , which is increasing in t, and the same holds for the baseline Schumpeterian model, where the probability is zv , t /q v, t t. What is relevant at this stage is that we can depart from the assumption made in these models that the firm that makes an innovation is granted a perpetual patent on it by instead analyzing the patent vs. trade secrecy decision of the innovating firm (say firm A). For this purpose, we will assume that formalizing a patent costs units more of the final than keeping the invention secret due to higher transaction costs, which is justified by empirical observations confirming this fact (e.g., Lerner (1994) points to much higher patenting costs than trade secrecy costs). The result of this stage is the binary decision of firm A regarding whether to keep the invention secret or patenting it.

2) Firm B decides, depending on what Firm A has chosen to do, whether to imitate or
leapfrog the invention of A. If firm A decided to patent, B can try to leapfrog (or invent around) As invention with a probability of success which is a function of the amount of effort exerted (in terms of final good units spent on R&D) for this purpose and the specific flow rate of innovations in industry i . Let the units of the final good invested in trying to surpass As patent be denoted by z P B 0, 1 and the innovations flow rate by i 0, 1 , where we use subscript i because these flow rate is different across industries, depending on their inherent characteristics. The probability that firm B is successful 1 in improving upon As invention can be modeled as: q P z P W i where W i is a i B i parameter that captures the amount of useful information for ulterior innovations that P is transmitted to competitors by the patented innovation. Clearly, q 0 , which means Wi that it is more likely to come up with new inventions when the patented innovation is very informative about where to direct research effort in order to maximize the odds of creating a new quality. The cost of R&D for B can be thought of as the opportunity cost of employing valuable resources in it instead of elsewhere, whose value can be P (so that we also let it differ across industries and across exogenously given by c P i Vi As decision to patent or not). The alternative decision for B is to do nothing, in which case it gets a payoff of zero. If, on the other hand, firm A decided to hide its secret instead of patenting it, then, again, firm B can either try to copy the invention or do nothing (we will see later the case where it can also try and leapfrog As innovation). If firm B tries to imitate, it will be successful S with probability q S , where i 0, 1 captures how easy it is to copy an invention i zB i by reverse engineering in that particular industry. Thus, high values of this parameter correspond to industries in which backward engineering is relatively effective in

unveiling the secrets behind the most advanced qualities (a real world example could be S the car manufacturing industry). As before, z B denotes the number of units of the final S good spent on this activity at opportunity cost c S i Vi

3) In this final stage, firms make their production decisions.

Given this structure of the game, we are left with defining the payoffs for the players. If firm A decides to patent and firm B invents around successfully, A is kicked out of the market and B stays as the sole monopolist. If it is not successful, we assume that it will earn zero (even after the patent has expired) minus the costs it needed to sink in order to undertake the research. If B decides to stay away from competing with A, it can imitate A for free at the end of the patent period, given by T. Let V M denote the present discounted value of the infinite stream of monopoly rents due to having the highest quality in the market and let future profits be exponentially discounted by the going P interes rate r. Then, when B tries to overtake A, it gets an expected payoff equal to q P i V M ci P P k . When B performs no action, we , while A gets, on average, 1 q i V M q i 0 assume that both A and B get duopoly profits (whose discounted value is given by V D ) upon the expiration of the patent since then B starts producing the same quality as A, so that the payoff for B is e rT V D and 1 e rT V M e rT V D k for A. For simplicity, we can think of the discount factor as a probability instead, so that we avoid the inconvenience of a continuous time model. This means that the q i s should be thought of as probabilities rather than hazard rates; that is, payoffs work in a way such that the time of arrival of innovations is known given the research effort. What the probabilities indicate is how likely it is that those dates are actually realized. We further assume that the probabilities already include the discount applied to future values. Thus, we can define the discount factor applied to the end-of-patent period as q e rT 0 . This way we are able to generate exactly the same expected profits as in a continuous time framework. This is the same as saying that everything in this model takes place at a single point in time. If firm A instead decides to keep it secret, firm B gets 0 and A gets V M if B does not try to S copy. If it tries to copy the invention, B will get an expected payoff equal to q S i V D ci S and A will get 1 q S . i V M q i V D We can represent this with the following matrix of payoffs: Firm A Firm B Patent Trade secrecy No action Imitate/leapfrog

1 q V M q V D k , q V D VM, 0

1 q P V M q P k, qP cP i i 0 i VM i
S 1 q S VM qS cS i i VD , qi VD i

Firm A will not patent as long as the following two conditions are met:

k VM VD
1

Wi S k zS zP i B i V D V M z B B i

The first of these equations always holds by definition since q e rT 0 and V M V D P P Now, for given z S , the second equation is more likely to B and z B , and as long as z S B i zB i hold when the hidden innovation is harder to copy by rivals, (because the value of the monopoly is greater than that of duopoly), the cost of patenting is higher, the arrival rate of inventions is higher (because in this case we run a high risk of being leapfrogged by firm B when patenting. It is important to note that we are assuming that the arrival rate does not affect the likelihood of imitating under secrecy. That is, we are assuming that innovation and imitation efforts are disconnected), the value of being a monopoly is lower, the value of a duopoly is higher (because in case of being imitated, at least he gets some positive revenues) and, finally, when the patent transmits too much useful information to B (meaning that A will be more inclined to hide its innovation).
1 Wi

In contrast, we cannot find a parametric condition by which Firm A will always patent no matter what Firm B does, since it will never pay for firm A to patent when Firm B chooses to withdraw from the race. The only possibility is that Firm A patents when B chooses to either imitate or leapfrog. In this case we need the following parametric condition to hold:
P Wi V M zS B i zB i
1

k zS iVD B

which is (obviously) the opposite of the condition above for the case of no patenting. Exactly the same logic, applied to the reverse case, goes through to analyse when this condition is more likely to be met: i) ii) iii) iv) v) vi) Higher value of monopoly profits (higher stake) Low k. Low value of duopoly profits (because, then, the difference between sharing the market with the other firm and having been kicked out is almost nil). The higher the risk of being copied is (again becauseV M V D ). The lower the risk of being leapfrogged is. The lower the amount of useful information transferred when patenting is.

Firm B will choose no action, no matter what Firm A does, whenever the following to conditions are satisfied:
i q V D z P V iP B i 1 W

S cS i q i V D

This means that the higher the opportunity cost of R&D, the more likely it is that firm B will choose to take no action. Similarly, the greater the probability of being overtaken by

a better quality or the higher the amount of information transmitted by patents, the lower the incentives to be idle. Analogously, Firm B will imitate/innovate whenever:
P qP i V M ci q V D S cS i qi VD

, which are exactly the same conditions as above but with the opposite direction of inequality. Nash equlibria:
(Patent, No imitation) impossible since A will always deviate and choose to hide the secret. (Patent, Innovate)
Wi i zP B i VM q VD VP 1 1

P Wi V M zS i B i zB

k zS iVD B here, the first inequality always holds.

(No patent, no action)

V M 1 q V M q V D k
S cS i q i V D S cS i qi VD
i V M zS zP i i B B 1 W

(No patent, imitate)

k z S iVD B

If the latter parametric conditions hold, only this NE can occur since they are incompatible with the other two. However, the fact that the conditions for the (P,I) equilibrium are satisfied precludes (NP, I) from happening, but it does not preclude (NP, NA). Similarly, the satisfaction of the inequalities in (NP, NA) precludes (NP,I) but not (P,I). Thus we would need to use a refinement concept in order to select among the different possible NE for some parameter restrictions. We can analyse when, for example, the (NP,I) equilibrium is more likely to hold as we 1 S P Wi did before. We have that (if and only if zB i z B i ) when the arrival rate, the information embedded in patents, the costs of patenting and the value of the duopoly are very high, the latter inequality is more likely to hold ceteris paribus. This is also true when copying is difficult and the value of the monopoly is not very high. Now, if we allow B the possibility of trying to leapfrog A when the latter chooses to keep its invention as a trade secret, then we would have three different possible actions for B and a matrix of payoffs that looks like:

Firm A

Firm B Patent

No action

Imitate

leapfrog
P P P 1 q P i V M q i 0 k , q i V M c i

Trade secrecy

1 q V M qV D k , qV D

1 q V M qV D k , qV D c P i
S S S 1 q S i V M q i V D , q i V D c i

VM, 0

1 qSi LV M qSi L 0, qSi LV M cSi L

Here we are assuming that if firm B decides to try to leapfrog firm A when the latter patents, it will spend so many resources that if it is unsuccessful, it wont be able to even copy the patented quality once the patent expires. The action of imitating when firm A has chosen to patent is obviously dominated by any other strategy, because firm B does not gain anything by imitating since it wont be able to commercialize its quality, since it is the same as the patented quality that firm A produces.
SL SL q SL i i z B denotes the probability of leapfrogging when B does not i f i , i , z B know exactly how A came up with its invention because it was not patented. This probability is a function that depends positively on all of its arguments, namely: the effort made in backward-engineering, the arrival rate of innovations in the industry and the level of easiness of copying.c SL is the cost of trying to overtake firm A measured V SL i i in terms of the opportunity cost of the resources that are employed in the reverse engineering effort instead of elsewhere.

zS B 0, 1 zP 0, 1 B