How innovation is killing free trade : a comparative case study of the effect of market size on the policy choices of developing countries to attract innovation

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HOW INNOVATION

IS KILLING FREE

TRADE

QUINTA DIJK

A C O M P A R A T I V E C A S E S T U D Y O F

T H E E F F E C T O F M A R K E T S I Z E O N

T H E P O L I C Y C H O I C E S O F

D E V E L O P I N G C O U N T R I E S T O

A T T R A C T I N N O V A T I O N

1 4 . 9 8 0 W O R D S F R I D A Y 2 2 J U N E , 2 0 1 8 M S C P O L I T I C A L S C I E N C E D H R . D R . S . K R A P O H L A S S I S T A N T P R O F E S S O R O F I N T E R N A T I O N A L R E L A T I O N S D H R . D R . L . L I N S I P O S T D O C T O R A L R E S E A R C H E R

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Acknowledgements

This study would not have been made possible without my supervisor, dhr. Dr. Sebastian Krapohl from the University of Amsterdam. I would like to show my gratitude towards my teacher and supervisor, dhr. Dr. Sebastian Krapohl, who has been a great help and support in the continuous process of this thesis. The ever-changing topics, questions, and insights were a challenge, but there was always room for talks and the sharing of thoughts. Furthermore, I would like to thank dhr. Lukas Linsi, for taking the time to and putting in the effort to read my thesis. In addition, Jelmer J. Koorn, has been of great help with this project. His patience and his listening ear have been a huge help in this process. Finally, a short thank you for everyone that I have neglected in the process and that have been patient enough to leave me to my work.

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List of Acronyms

ANFAVEA Associação Nacional dos Fabricantes de Veículos Automotores BRICS Brazil, Russia, India, China and South Africa

CAAM Chinese Association of Automotive Manufacturers DoI Diffusion of Innovation

EV Electric Vehicle

FDI Foreign Direct Investment GII Global Innovation Index

GIPC Global Intellectual Property Center GDP Gross Domestic Product

INSEAD Institut Européen d'Administration des Affaires IP Intellectual Property

IPR Intellectual Property Right IPRI Intellectual Property Right Index ITT International Technology Transfer

JV Joint Venture

LCR Local Content Requirement MNC Multinational Corporation MSSD Most Similar Systems Design

OECD Organization for Economic Co-operation and Development OLI Ownership, Location and Internalisation

PIIE Peterson Institute for International Economics PPP Purchase Power Parity

R&D Research & Development S&T Science & Technology

TRIM Trade Related Investment Measure TT Technology Transfer

UNCTAD United Nations Conference on Trade and Development US United States of America

WIPO World Intellectual Property Organization WTO World Trade Organisation

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List of Figures

Figure 1: The Diffusion Process 7

Figure 2: Categories of Innovativeness 9

Figure 3: Five Stages in the Decision Innovation Process 9

Figure 4: Aspects of similarity between cases 21

Figure 5: Industry Electric Vehicles Index (EVI) 23

Figure 6: Process Tracing Causal Mechanism 24

Figure 7: Electric Vehicle Index (EVI) 30

Figure 8: Phasing-out of petroleum cars and adoption of EVs 34

List of Tables

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Abstract

While the literature provides ample information on the role of FDI in innovation and the motives behind this, little is known about the policies that developing countries implement to acquire innovation. This provides a new dimension to international technology transfers (ITT), carrying significant implications for both investors and developing countries. By means of process tracing, this study attempts to measure the impact of market size on the decision-making process for developing countries on acquiring innovation within the electric vehicle (EV) industry. In specific, this study investigates the cases of China and Brazil. This study concluded that market size is a decisive factor for the policy that developing countries choose regarding innovation acquisition. If market size is large, trade policy is the preferred policy to attract innovation, whereas a small market size indicates a preference for IPR policy to attract innovation. This study contributes to the literature by highlighting the perspective of the developing country and its policies for innovation attraction and provides a roadmap for countries on what to expect and do in similar situations. Keywords: innovation, intellectual property, international technology transfer,

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1. Introduction

“A slow sort of country’ said the Red Queen. ‘Now here, you see, it takes all the running you can do to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!” - Lewis Carroll, Alice through the Looking Glass

Innovation, globalisation, and uncertainty are not new, and one thing we can be certain about is that the environment of tomorrow will be just as uncertain is the one of today. This obvious contention is a clear reminder of the immense difficulty of managing innovation. We are attempting to keep up in the presence of an ever-changing backdrop. Some trends in this ever-ever-changing backdrop are converging towards conditions that have the ability to completely rewrite the rules of the competitive game. Under the current competitive conditions it is becoming clear that many industries are increasingly dependent on (technological) knowledge as their competitive advantage. Knowledge is difficult to duplicate and in turn obliges other firms to go through an analogous learning process to get the knowledge. Consequently, there is an incentive to acquire certain knowledge sooner rather than later, which places emphasis on how firms manage their knowledge base and on developing successful apparatuses for resourcing technological knowledge. Firms will need to ensure that there are capabilities so that technology transfers can be diffused and absorbed effectively. The main diffusion mechanism that is in place for transferring innovation is Foreign Direct Investment (FDI) flows.

Fervent academic endeavours have been aimed at explaining FDI motives and the consequential tariff jumping (Erdal & Tatoglu, 2002; Hwang & Mai, 2002), as well as the influence of domestic factors on these motives. Nonetheless, negligible attention has been given to address how some of these factors influence policy choices of host countries to anticipate on FDI motives. One such factor is market size, which serves as a rationale for foreign investment activities relating to innovation. Although market size has been traditionally claimed to explain market attractiveness and serve as an initiative for FDI, the growing magnitude of FDI attraction on the side of the developing countries appears to stand at odds with traditional FDI theory. It

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furthermore accentuates the necessity to understand the ways in which developing countries attempt to attract FDI in order to gain intellectual property and further their development. Notably, it poses questions about the role of market size in developing countries’ policy choices regarding innovation acquisition.

In order to find a solution for the challenges mentioned above, the phenomenon of tariff jumping in developing countries is crucial and requires a further investigation. Market size is an essential factor here because it embodies part of the decision-making process of FDI flows towards developing countries and inherently carries weight to innovation. Therefore, this research will attempt to identify the importance of market size that explains foreign investment behaviour of electric vehicle manufacturers in developing countries. As such, the main question of this research attempts to answer is: “In what way does market size determine the policy choice of

developing countries on acquiring innovation?”

This research is of great relevance for two main reasons. From an academic point of view, the explorations of market size as a determinant of policy considerations can further the understanding of the role of developing countries in international technology transfers (ITTs). This area of research has been highly overshadowed, presuming that the source of FDI was of higher influence than the receiver of FDI. However, this study determines the importance of policy-making on the part of the developing country, contributing to the currently insufficient literature on FDI as a means of technology transfer. From a social perspective, this research can shed light on the role of developing countries in FDI flows, which appears to be less reactive and more proactive. This objective can be instrumental in raising awareness on this issue given the policy implications that are related to this topic.

In the following chapter (chapter 2) an overview of the relevant literature is given in order to establish the research niche of this study. Followed by this literature review is the established theoretical foundation for this research, which explains how market size is a defining factor for tariff jumping. In the fourth chapter, the research has linked the arguments derived from the theoretical framework to the research question and two hypotheses have been formulated. Consequently, this study presents the

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well as justifications for the selection of cases. In turn, the analysis describes how market size is influential in FDI attraction and establishes for each case the size and attractiveness of the market. Finally, on the basis of the hypotheses and the comparative case study, the research results have been summarised and theoretically interpreted in chapter ten. Possible directions for future research on this area and the limitations of this study have been outlined in this section as well.

2. Literature Review

“It ought to be remembered that there is nothing more difficult to take in hand, more perilous to conduct, or more uncertain in its success, than to take the lead in the introduction of a new order of things. Because the innovator has for enemies all those who have done well under the old conditions, and lukewarm defenders in those who may do well under the new.”

- Niccolò Machiavelli, The Prince, Ch. 6 In order to explain how market size affects how developing countries acquire innovations in the Electric Vehicle (EV) industry, it is important to understand the different dimensions of the topic. As the study of innovation and its diffusion is not a new one, it covers a broad range of perspectives and dimensions. As such, it dates back to the 20th century, meaning that the circumstances and with it the interpretation of innovation have changed and evolved over time. Accordingly, it also touches upon a rather extensive range of International Relations, social, and economic theory. In fact, the configuration of this study is to build a bridge between these academic fields and the recent developments in innovation in order to comprehend how the differences in innovativeness and the respective market size are translated into policy decisions on knowledge acquisitions. Accordingly, a review of the relevant key terms, processes, and their effects will be given to identify the characteristics that have created these circumstances, but also what has been lacking in the literature up to now. Based on this information, a synergy of theories will form the basis for the analysis of market share and knowledge gaining.

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As was presented in the introduction, this research is aimed at answering the question:

“In what way does market size influence the policy choice of developing countries on acquiring innovation?” With the goal to identify the type of policy of developing

countries as a result of market share, it is crucial to understand three things in the process: what is innovation and why is it important, what is diffusion of innovation, and how is market share related to innovation. Firstly, it is important to understand what is meant by innovation. This has evolved over time and is important to understand when we analyse the policy choices of developing countries. Secondly, an analysis of innovation diffusion and knowledge acquiring provides insights into how developing countries relate to the existing innovation theory and their policy choices. There are several examples of states that occupy trade barriers to investment in order to force manufacturers to produce domestically and to obtain technological knowledge. The scope of this research focuses on the impact of market size on the decision of developing countries to use either trade policy or Intellectual Property Rights (IPR) to attract FDI and thus innovation. Consequently, it is important to understand what innovation entails and how it affects countries. It is further important to understand the mechanism through which innovation is transferred from technologically shrewd countries towards technologically backwards countries.

2.1. What is innovation and why is it important?

Innovation is commonly recognised as one of the main elements of the industrialisation process and the catching up of developing countries to the standard of western, developed economies. As innovation is risky and thus also costly, groundbreaking innovation has been limited to a few rich countries, with resources coming from specific forms of university science and research capacity. However, our society has entered the arena of the knowledge economy, which in turn means that science and technology have gained a prominent position in the competition from trade for both nations and firms. For this reason, many developing countries rely on external sources for the supply of technological know-how, as their domestic situation does not provide these conditions (Zanello, Fu, Mohnen, & Ventresca, 2016). But innovation theory has also evolved over time, which is why the most important theories are explained in this section.

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2.1.1. What is innovation?

The beginnings of the innovation scholarship date back to the early 1900s with the work of Schumpeter (2017), where he introduces the circular flow diagram as a basis for development. “The circular flow is a stream that is fed from the continually flowing springs of labour power and land and flow in every economic period into the reservoir which we call income, in order to be transformed into satisfaction of wants” (Schumpeter, 2017). Generally speaking, the circular flow is static and the only possibility to make it dynamic and in line with development is to make changes to this flow diagram. These changes come about through innovation. Innovations can be defined by the change in the existing production system in order to make more profit and reduce costs. Consequently, innovation is a form of disruption to the existing system that forever changes the current equilibrium, making innovation inherent to economic activity. These changes can take the form of several different examples (Schumpeter, 2017; Zhao & Gao, 2008):

• Introducing a new product;

• Introducing a new form of production; • Opening up to a new market;

• Acquiring a new supply source of raw/natural resources or semi-manufactured goods;

• Carrying out a new form of business organisation in the industry, such as creating a monopoly.

From this follows that innovation is not only technological, but can take on an array of types: goods, but also services and organisational structures. Consequently, innovation can occur in different stages and different sectors. Schumpeter differentiates four stages of innovation: (i) the initial invention, (ii) efforts to commercialise, (iii) the diffusion of innovation, and (iv) the imitation by others (Kennedy, 2018). In essence, the purpose of innovation is not to create technique, but to use technique to create economic benefits. In Schumpeterian development theory, the center and igniter of the development process, and thus also innovation, is the entrepreneur. This still holds, as manufacturers are believed to be the center of upgrading technology and organisational practices for developing countries (Juma &

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Yee-Cheong, 2005). Further development of this theory leads us to believe that states can also participate in innovation; this is elaborated on in section 2.1.1 (Zhao & Gao, 2008).

2.1.2. Why is it important?

Today it is a well-known theory that innovation drives long-term economic growth and social development (Juma & Yee-Cheong, 2005). In part, the reason for this is the increase in productivity that is accompanied with innovation. Furthermore, innovation is linked to job and income growth. Cross-country firm-level data of the Organisation for Economic Co-operation and Development (OECD) provides insights in the positive link between technology-using industries and higher productivity and overall employment (OECD, 1998). These factors are crucial for long-term prosperity. Additional to the economic benefits and importance of innovation, innovation is also considered fundamental to human development and improvement of quality of life (Kennedy, 2018). Innovation is behind improvements in industries such as health care, education, transportation, and environmental protection. These topics have become increasingly important over the last decades and will continue to take a prominent position in our world. Overall, societies and firms seek innovation for three different reasons. Firstly, innovation helps continuously increase the standard of living in countries. Secondly, countries seek to increase their level of competitiveness in the international market by innovation, which leads to increased exports and better terms of trade. And thirdly, there is a growing societal need for innovation and development needs to keep up (Ezell & Atkinson, 2010).

2.1. Diffusion of Innovation Theory

The previous section explained how (technological) innovation is costly and risky. Consequently, most innovation activities take place in a few developed, rich countries, such as the United States (US), Japan, and some European countries. This could explain why developing or poor countries rely on attracting foreign technology for their development rather than creating it themselves. Hence, international technology diffusion is a very important condition for economic growth in countries that lack innovation capacities. This is established in the diffusion of innovation (DoI) theory, which answers how, why, and at what rate new ideas and technology spread. Everett Rogers first introduced the diffusion of innovation theory in the 1990s. There

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communication channels, (iii) time, and (iv) the social system (Rogers, 1995). Diffusion covers the process by which innovation is transferred among the members of a social system through certain communication channels over time, which is visually presented in Figure 1.

Figure 1: The Diffusion Process1

Where Schumpeter had a simplified version of the adaptation of innovation, namely the entrepreneur came up with an innovation and this was either successful or not, Rogers’ DoI theory expands on the process of this adoption or rejection of innovation. A new idea is invented, then diffused, and lastly either adopted which ignites change or rejected and which results in stagnation. This emphasizes the active role of innovation, rather than plainly implementing the template of a new idea.

Similar to Schumpeter, Rogers explains that innovations do not have to be focused on products only, but that they can take a range of forms, such as new forms of production or a different application to an already existing phenomenon (reinvention) (Rogers, 1995). In doing so, some innovations may be adopted relatively quicker than others. This difference can be linked to the relative use for the consumer or receiving party. When an innovation is perceived as having greater relative advantage,

1_{Figure taken from E.M. Rogers, Diffusion of Innovations, 4th Edition (New York: The Free}

Press, 1995).

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compatibility, observability, and trialability, together with less complexity, individuals will be more likely to adopt the changes and DoI takes place more rapidly (Rogers, 1995).

Given the fact that these innovations exist, there is a need for communication channels to spread the innovations. Interestingly, several studies conclude that individuals do not adopt an innovation based on scientific results or knowledge, although they do play a less significant role, but are more likely to adhere to subjective evaluations of peers (Rogers, 1995). Mouth-to-mouth DoI appears to be the most efficient and most successful type of diffusion. Another aspect of the communication channel is the heterogeneity of the group that is addressed. This means that there is a risk of miscommunication in addressing the innovation, as the individuals have a different (professional) background. However, a certain degree of heterogeneity is required for diffusion to take place, since homogeneity would make sure that there is no new information that can be diffused (Rogers, 1995).

Time plays a significant role in the innovation process in different categories: (i) the innovation-decision process, (ii) the innovativeness of the individual, and (iii) the rate of adoption. Time is of essence when an individual makes up his mind about an innovation, as this is where different attitudes are addressed towards the innovation (Rogers, 1995). This is also the process in which the individual decides to either adopt or reject the innovation. The second category regards the level of innovativeness an individual has. Is an individual eager to learn new things, than one can be considers an innovator. On the other side of the spectrum we hate laggards, which contain people that are not concerned with innovations at all and only come into the process of diffusion very late. Figure 2 contains a visual representation of these categories. These different individuals form the social system in which the diffusion takes place. Usually, the social system is made up of consumers and/or firms in the sector that is addressed with the specific innovation. The different categories of people take up different roles within the social system and consequently influence the diffusion process. Furthermore, some innovations might be diffused as an option, but more as an authorative decision.

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Figure 2: Categories of Innovativeness2

Overall, there are several stages through which a new idea passes before the decision to adopt or reject is made. These are depicted in the diagram below.

Figure 3: Five Stages in the Decision Innovation Process3

All these aspects influence the diffusion of innovation process with regards to the social system it is operating in.

2.1.1. Global Innovation

Rogers’ DoI theory mostly focuses on individuals in the social system. However, the 1990a also signify the globalisation era. This created an additional, much larger, social system: the global arena. Here, we can qualify the social system as the countries that are part of this global arena. Countries with abundant resources in

2_{Figure taken from E.M. Rogers, Diffusion of Innovations, 4th Edition (New York: The Free}

Press, 1995).

3_{Diagram as interpreted from E.M. Rogers, Diffusion of Innovations, 4th Edition (New York:}

The Free Press, 1995).

Five stages in the Decision Innovation Process

Knowledge Persuasion Decision

Accept

Reject

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Research & Development (R&D), highly educated people, and monetary funds, are more likely to innovate and will therefore end up on the left side of the curve (this is also specified in section 2.1). On the other hand, countries that lack these resources are less likely to innovate and will then end up on the right side of the diagram. In conclusion, countries in different stages of development can be sorted in different categories of innovativeness (Juma & Yee-Cheong, 2005).

Most developing countries attempt to move up the innovativeness curve and increase their level of innovativeness. In order to do that, they need to acquire technological knowledge from the more developed countries (Fu, Pietrobelli, & Soete, 2011; Zanello, Fu, Mohnen, & Ventresca, 2016; United Nations Conference on Trade and Development, 2011).

2.2. Channels of International Technology Transfers (ITT)

There are several transmission mechanisms through which technology can de transferred across countries and region, both market channels as well as non-market channels (Maskus, 2004). Non-market channels include the imitation of goods, the departure of employees that start a rival firm, and temporary movement of people through migration, travel, and foreign education. Market include the following six mechanisms: (i) movement of goods and services through international trade; (ii) movement of capital through FDIs; (iii) cross-border movement of personnel people; (iv) international research collaborations; (v) diffusion through media and internet channels; and (vi) integration into global value chains (Fu, Pietrobelli, & Soete, 2011). FDI as a collection of technological and managerial knowledge and as financial capital has been considered a main driver for the transfer of advanced foreign technology from developed to developing countries for a longer period of time (Dunning J. H., Multinational enterprises and the globalization of innovatory capacity, 1994; Lall, 1992; Fu, Pietrobelli, & Soete, 2011). This is not surprising, as empirical studies have shown that FDI as a technology transfer has had positive effects on developing countries (Eden, Levitas, & & Martinez, 1997; Kokko, Tansini, & Zejan, 1996; Buckley, Clegg, & Wang, 2002). It is for this reason that this study focuses on FDI attraction as a means for developing countries to acquire technological knowledge.

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2.3. Research Gap

After this extensive literature review, it becomes clear that the focus of the current literature is highly one-sided. There is a large body of literature that focuses on the home country’s perspective of diffusion, meaning that scholars have explored the field of FDI motives and how this transfers technology to less-innovative countries. However, much less research has been conducted on the host country’s perspective – this being the perspective of the country towards which the FDI is flowing. It is interesting to know what factors influence the policy-making process of host countries in their quest to advance innovation in their economy. What could be the determining factor for host countries to base their policy on for innovation advancements? This study attempts to provide insights into the ways that host countries stimulate the growth of FDI in order to gain technological knowledge and further their innovation level.

3. Theoretical Framework

Many a theory has been developed to explain the existence and impact of FDI flows, both microeconomic and macroeconomic theories. Microeconomic theories focus on the firms specific characteristics that influence the decision making on FDI flows, such as the market imperfections theory, which argues that multinational corporations (MNCs) came into existence due to market imperfections and firms tried to “internalise the relationship between licenser and licensee by establishing monopolist type of advantages through vertical integration” (Kalfadellis & Gray, 2002, p. 6). Macroeconomic theories gather information on country characteristics that explain FDI flows within and between countries, including theories on internalisation and product cycles, but also FDI motives regarding market, resource, or efficiency seeking. Considering the fact that this study focuses on the diffusion of innovation between countries, this study will concentrate on the macroeconomic theories of FDI, specifically dedicated to the FDI motives.

The previous chapter explained how developing countries are still highly dependent on foreign countries for technological progress, because innovation is a risky and uncertain process that makes it expensive to engage in. Because of this, the process of innovation is rather inaccessible to developing countries. Accordingly, developing countries attempt to innovate mainly through adoption and adaptation of technologies

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from developed countries rather than creating new technologies domestically. “The experience gained by developing countries that have tapped into [M]NCs’ knowledge networks, illustrates that FDI can help enhance skills, transfer competencies and strengthen manpower” (United Nations Conference on Trade and Development, 2011, p. 17). Therefore, the transfer and diffusion of technological knowledge is crucial to building domestic technological capabilities. The transfer of this knowledge can happen through both FDI and non-equity forms of involvement, however this paper only takes into account the FDI linkages as these are considered most significant by the academic community.

3.1. Diffusion of Innovation through FDI

Foreign investment can result in considerable benefits for the host country, even when the wards firms decide to produce in fully-owned affiliates, because technology is to some extent a public good to which people cannot be excluded (Blomstroem & Kokko, 1998). These benefits can be considered as externalities to the investments, commonly referred to as “productivity spillovers” (Blomstroem & Kokko, 1998). These include hiring workers that are trained by the MNC or the possibility of imitating and/or copying technologies or products, but also when increased competition in the host country forces firms in this market to innovate. Either way, they are relatively cheap ways of stimulating innovation. It is important to note that these spillovers merely occur because the home country is not able to fully internalise the added value. However, they are very important to the host country, as these technologies are not available in the host country. Another reason for the importance of these spillovers is the diffusion of innovation; by bringing the innovations to a different society, the process of diffusion speeds up (Blomstroem & Kokko, 1998). These spillovers can be clearly understood as a benefit to the host country. Now the question remains what the motives of the home country are to engage in FDIs. If countries attempt to engage in FDI, there is a need for incentives to start investing. The following section will elaborate on the different motives for home countries to invest in innovation-lacking countries.

3.1.1. FDI Motives

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paradigm (Dunning J. H., 1993; 2010) from the seventies. The eclectic paradigm provides a framework on ownership, location, and internalisation (OLI) advantages that analyse why (ownership advantage), how (internalisation advantage), and where (localization advantage) firms invest abroad (Dunning J. H., 2010). He identifies three forms of international production:

• (i) Market seeking. Market seeking refers to a firm’s intention to exploit a foreign market that is of a greater dimension than the domestic market. This means that products will be sold in the local market and are most of the times also produced in the host country (Asiedu, 2002).

• (ii) Resource seeking. Resource seeking has the aim of acquiring natural resources of a specific region that is not available in the home country or that can be obtained at a lower price (due to cheaper labour or lower labour standards).

• (iii) Efficiency seeking. These take place in two occurrences: to “take advantage of differences in the availability and costs of traditional factor endowments in different countries” or to “take advantage of the economies of scale and scope and of differences in consumer tastes and supply capabilities” (Dunning J. H., 1993, p. 60).

The first two forms are the most debated in the literature and are respectively referred to as horizontal and vertical FDI (Franco, Rentocchini, & Marzetti, 2008). Horizontal FDI are mostly motivated by lowering transportation costs or by tariff jumping, where the decision is made to either export or to set up a foreign plant (Markusen, 1984). It is called horizontal FD, because companies duplicate their whole production process to a different location. Vertical FDI is mostly considered with lower costs of the production factors and will therefore aim at relocating parts of the firm within the production process (Helpman, 1984). For this reason, this type of FDI is called vertical: different stages take place in different locations, still operating for one firm. Both of these motives focus on the cost aspect of the decision.

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Some scholars (Deng, 2007; Pradhan, 2010; Meyer, 2015) argue that a single category is still missing from Dunning’s OLI analysis and that is:

• (iv) Strategic Asset seeking. In this case, investment takes place with the desire to acquire technological knowledge rather than exploiting existing assets.

The previous section provided insights into the home country’s motives and how developing countries have the opportunity to anticipate on that. However, host countries also have their own characteristics that attract FDI or even “force” companies to produce locally. Now the question remains what factors that are connected to the host country have an effect on these FDI motives. This side of the story has been rather underexposed in the literature. The following segment provides the researcher’s thoughts on this.

3.2. Attracting FDI

There are many factors that influence the attractiveness of FDI for home countries. Many of these factors are located in the host country and are considered and are considered inherent not just to the economy, but also to the society as a whole. Among the societal factors that are of influence to FDI attraction and spur innovation are factors relating to the institutional arrangements in the host country. These include stable political environments, law enforcements as affecting FDI inflows, but also an entrepreneurial culture and support for a robust science and engineering workforce (Lecraw, 1991; Zanello, Fu, Mohnen, & Ventresca, 2016; Ezell, Nager, & Atkinson, 2016). Economic factors that are mentioned as affecting FDI inflows include factors such as economic openness and financial support (Haiyang, 2005; Zanello, Fu, Mohnen, & Ventresca, 2016). Many scholars have addressed these conditions as important to FDI inflows and have adopted frameworks in which these societal and economic factors have been elaborately put together and explained. An area that has received much less attention, but is not less influential in the process, are market conditions. Few scholarships have used these factors in their analyses, making it all the more important to take it into consideration for this study.

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In order to maximise innovation, there are certain market conditions that need to be met. More specifically, there are three factors that influence the maximisation of innovation: (i) large markets, (ii) limiting competition, and (iii) strong IP protections (Ezell, Nager, & Atkinson, 2016). Investing in innovation is uncertain and risky making the process very expensive and prone to failure. In turn, firms need to sustain higher levels of profits in order to earn back the investments; this is what we call “Schumpeterian profits” (Ezell, Nager, & Atkinson, 2016). As developing countries do not feature the technological knowledge of the manufacturing companies that aim at producing and competing in that country, the risk of sincere increase of competition is limited. These manufacturers will have a significant comparative knowledge advantage with the domestic manufacturers in the host country. It is for this reason that this condition is not regarded in this study. The other two conditions are explained in the following sections.

3.2.1. Market Size and Attractiveness

Wherever there is a market to serve, companies will exist to fill that place. Expansion of markets is then a logical part of business life, but is not necessarily an easy one. There are many considerations attached to deciding a relevant market. One of the main concerns for manufacturers is profitability, where choosing a market is based on factors influencing the profits of the firm: the higher the profit expectations of the firm, the higher the attractiveness of the market (Almgren, 2014). Accordingly, a market is more attractive when there is a higher possibility of increasing profits. One factor that influences the attractiveness of a market is market size (Soberman & Gatignon, 2005). The reason for this is that market size gives the firm some insights on the possible successfulness of the firm; you can establish the amount of potential buyers. This is important, as it is essential to have a large consumer base to sustain growth. A smaller market will not provide the same profit increase as a bigger market, since fewer consumers buy your product and not enough revenue will be extracted (Almgren, 2014; Erdal & Tatoglu, 2002). Furthermore, a larger market increases the opportunities for economies of scale, specialisation, and market segmentation, while also reducing the transaction costs (Gupta & Govindarajan, 2000; Mitra & Golder, 2002). Consequently, this leads to higher revenues and higher profits (Erdal & Tatoglu, 2002). These factors can be described as the “Schumpeterian profits”, which are profits that arise from appropriating the returns of innovation activities.

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Considering the risk that is involved in undertaking innovative activities, firms aim for higher returns to earn back on the risk. Moreover, the higher returns allow for further investment in Research & Development, which in turn further stimulates innovation. A larger market size also indicates opportunities for new entrants and new segments, which stimulates economic growth and development (Arnold & Quelch, 1998). Summarising, market size has a positive effect on the attractiveness of a market by increasing profits and stimulating growth.

From the above-mentioned section we can conclude that market size will be even more important to companies with a market seeking strategy. Considering the aim of these companies is to serve a bigger market and increase the sales drastically, a big market is a crucial factor for success.

3.2.2. Market Attractiveness and FDI

Considering that market attractiveness is linked to sustainable growth and higher profits, countries with such an attractive market attract more FDI (Brouthers, Gao, & McNicol, 2008). This sustainable growth provides a secure environment to make risky and costly investments, because the chance of earning back the investment is high. When the chances of earning back your investment are high, the possibility and opportunity for FDI increases.

3.2.3. Intellectual Property and Innovation

In today’s society it is generally accepted that technological innovation is necessary to achieve successful performance for the firm, as it is competing in a knowledge-driven and competitive business environment. Considering innovation refers to the development of a new idea, regarding aspects such as products and organisational structures, and bringing new value to the customer, intellectual property takes a prominent place in this realm. Intellectual property (IP) signifies “unique, value-adding creations of the human intellect that results from human ingenuity, creativeness, and inventiveness” (Kalanje). Consequently, the IP system in considered absolutely necessary to innovation “to encourage creative intellectual endeavor in the public interest” (Ricketson, 1991, p. 398). Furthermore, the IP system is of great importance in gaining and maintaining an innovation-based advantage in the market. Accordingly, IP rules are of essence in creating and retaining a competitive market place for technology-based companies. Additionally, there are many players that help

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facilitate the market success of an innovation, which means that sufficient use of the IP system play an important role in reducing the risks involved for innovative firms and helping these firms bring the innovation to the market (Kalanje). The challenge, in short, is that “intangible capital assets (such as IP) are more easily appropriable than tangible capital assets” (Ezell, Nager, & Atkinson, 2016, p. 13). Summarizing these remarks, IPR are of high importance to technological innovation.

3.3. Policy Choice

The previous segment showed that there are different aspects to the domestic environment of developing countries that influence FDI flows. This leaves these countries with a choice as to the policy they adopt to anticipate on these flows. Broadly speaking, there are two global governance regimes: trade policy and IPR policy (Curtis, 2012). These two regimes are contending and somewhat contradicting each other in their aims and desires. Supporters of the trade policy regime have as desire to maximise economic self-interest of a region using trade policy. Contrary to this regime, the IPR regime has the desire to harness and utilise innovative and creative forces through granting and exercising IPRs. It has appeared challenging to combine and balance these two conflicting views both within the domestic society as well as the world as a whole.

Economic activity and welfare is increasingly dependent on knowledge creation and innovation, with some countries owning more innovative knowledge than others. Accordingly, the question is how other countries get access to this knowledge given certain time and costs, while concurrently making sure that innovation and knowledge creation is sustained. These two regimes provide different perspectives and a different answer to this question. In the scope of this study, the trade policy supporters go about this by forcefully acquiring technological knowledge and using it to get to a higher innovation level. Countries taking up the IPR policy focus on the stimulation of FDI through the protection of IPRs and providing an attractive environment for manufacturers to produce abroad.

3.4. Concluding Remarks

From the theoretical framework leads that extensive research has focused on the importance of market size and FDI attraction. Furthermore, a large body of literature has studied the link between FDI and innovation. However, we are missing a

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comprehensive framework that connects the two fields of study and relate market size to the policy choice that developing countries make to attract innovation.

4. Hypotheses

As has been presented in the introduction (chapter one), this research is aimed at answering the following research question: “In what way does market size determine

the policy choice of developing countries on acquiring innovation?” Under the goal

of determining the influence of market size on the policy decision of developing countries on acquiring FDI and innovation, it is crucial to understand the motives behind FDI flows from developed countries and how innovation-lacking countries anticipate on this.

It is widely accepted that there are six ways in which ITT can take place: (i) movement of goods and services through international trade; (ii) movement of capital through FDIs; (iii) cross-border movement of personnel people; (iv) international research collaborations; (v) diffusion through media and internet channels; and (vi) integration into global value chains (Fu, Pietrobelli, & Soete, 2011). From these six different mechanisms, FDI is considered the most influential mechanism of DoI. As the DoI is clearly beneficial for the country on the receiving end of the FDI, it leaves the question to what the rationale behind the investments is from the investor’s side. These motives can be categorised in the following three groups: (i) market-seeking, focusing on the advantages of a large market; (ii) resource-market-seeking, taking advantage of natural resources not available in the home country; and (iii) efficiency-seeking, regarding the efficiency gains from alternative factors (Dunning J. H., 1993). Developing countries have the opportunity to anticipate on these motives and influence their behaviour to become more attractive to investors. The aspect of market conditions is largely ignored and needs emphasis, with market size proving a significant factor for attractiveness of FDI.

From theory we predict that if a market is large, a country will adopt trade barriers to prevent companies from penetrating the market without compromising their IP. As the market is so rich in potential, companies will want to omit these tariffs by producing their product in the host country rather than exporting it, this is referred to as tariff jumping. As such, countries with a large market can force companies to

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transfer their IP. On the other hand, if the market size is small, a country will focus on actively attracting FDI to their country. As the market potential is less prospective for companies, they will have to make their market more attractive by ensuring companies that their IP is protected. Although, this is initially not beneficial for domestic companies, theory shows that countries can still benefit from the influx of foreign companies by taking advantage of the (innovative) spillovers they bring. This leaves developing countries with a choice between two contending policy regimes: trade policy and IPR policy. Thus, based on theory we can formulate the following two hypothesis:

Hypothesis 1: Countries with a large market size will be more effective in attracting FDI and will in turn use trade policies to (forcefully) acquire innovation.

Hypothesis 2: Countries with a small market size will be less effective in attracting FDI and will in turn use IPR policies to acquire innovation.

In order to investigate these hypotheses, the following chapter provides the research design and methods to this study. This outlines the causal mechanism and provides the scope of this research together with different in-between steps that can be deduced from this theoretical framework.

5. Research Design

5.1. Scope

As the broader research gap encompasses a large variety of policies and industries, it would be irresponsible to study the responses on the varying topics that can be addressed. For this reason, the scope of this research will be narrowed down to one specific industry, specifically the electric vehicle industry.

5.1. Electric Vehicle Industry

Thomson Reuters (2015) published a report in 2015 on the patenting behaviour in the automotive industry over the period between 2009 and 2014. This report stated that the automotive industry had the third highest patenting activity than any other economic sector, behind computing and telecoms, but it showed the highest increase

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out of any other sector in this period. While 2009 showed the filing of fewer than 2000 patents in the automotive industry, this increased to almost 12.000 patents in 2014 (Thomson Reuters, 2015). This is only one of many indicators for the innovative level of the EV industry. In general, the eagerness of new products within the automotive industry is considered rather high when compared to other high-tech products, making this an important industry for innovation (Tellis, Yin, & Bell, 2009). Broadly speaking, the EV industry poses changes to the existing industry of the automotive industry, as new technology allows for alternative ways of driving. This also creates opportunities for additional products in the industry to be developed, such as batteries and auto parts, but also new products such as charging stations. Hence, investigating this industry is highly applicable and important.

5.2. Comparative Case Study

In order to fulfill the scope of this research and test the hypotheses as established above (in section 4) comprehensively, a comparative case study design with two cases is selected to understand how developing countries use different policies to acquire innovation depending on their market size within the electric vehicle industry. A comparative method is very suitable to this study’s design, as it uses empirical data to determine relationships between two or more conceptual variables, while holding other factors constant (ceteris paribus) (Yin, 2017; Gerring, 2004). This study neither has an experimental nor a statistical basis, thus the case study method can be used to test the validity of the theoretical propositions and comment on possible differences in outcomes of cases that exist in similar contexts (Lijphart, 1971). This research will base its comparative analysis on the most similar systems design (MSSD), as this can explain the dependent variable (policy choice) in the presence of the market size, where differences in market size will determine the policy choice. Accordingly, this can compare countries that differ on most aspects, except for their lack of innovation and their desire to embrace the EV industry.

5.2.1. Case Selection

Broadly, there are three consequential categories in which we can compare the cases. Figure 4 shows these subsequent similarities of the two cases that have been selected, which will be further described in this section.

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Figure 4: Aspects of similarity between cases

The economies within the global trading order can broadly be divided into two distinct groups based on their level of development: (i) developing economies and (ii) developed economies. The scope of this research is how market size affects policy-decision regarding innovation acquirement, which relates to developing countries. It is therefore important to select cases from the developing group in order to research the policy choices for innovation acquisition. The two countries that have been analysed are: China and Brazil. Both countries are categorized as developing and are part of BRICS (BRICS, 2017).

Their level op development is closely linked to the category of innovativeness that each country adopts. As has been established earlier on in this study, the level of development and amount of resources strongly influence the amount of innovation that takes place in the economy. As the different countries are in different stages of development, they are also in different stages of innovativeness. The countries seeking innovation are far behind on rich, developed countries, which confirms their desire to play catch-up and move up the innovativeness curve. According to the Global Innovation Index (GII) of 2017, China and Brazil are on similar sides of the spectrum where China ranks 22nd on the list, whilst Brazil ranks 69th on the list (Cornell University, INSEAD and WIPO, 2017). Accordingly, China can be considered part of the “Early Majority”, as being in 22nd_{place officially puts you in} the 34% of “Early Majority” of Rogers’ categories of innovativeness:

22

127 × 100% = 17.32% > 16%

Brazil, with its 69th_{place, is part of the “Late Majority”:}

69

127 × 100% = 54.33% > 50%

These differences in innovativeness also influence the need for FDI that the two cases have compared to the developed countries. Both cases have a strong desire to move

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up the value chain and move up the innovation curve. In order to do exactly that, the countries need to gain access to IP of technological knowledge so they can also innovate. Consequently, the two countries need to attract FDI to achieve this goal and they are both using different trade related investment measures to get there.

Apart from their similar development stage and lack of innovativeness, both cases have significant interest in the EV industry. China is now leading in the EV industry, according to a new report of McKinsey (as can be seen in Figure 5). Chinese companies “produced 43 percent of the 873,000 EVs built worldwide in 2016” (Hertzke, Müller, & Schenk, Dynamics in the global electric-vehicle market, 2017). Furthermore, the country now has the most EVs on the road, overtaking the US market for the first time. The reason for this increased interest lies in the goal to reduce emissions drastically by 40-45% over the period of 2005-2020, as they committed at the Copenhagen Summit in 2009 (Cui, Fan, Zhu, & Bi, 2014). Their Twelfth Five-Year Plan (2011-2015) (Central Committee of the Communist Party of China, 2011) stipulates this goal into a national target for reducing the nation’s carbon intensity by 17%. “China has set ambitious targets for domestic Electric Vehicle (EV) development and deployment: The target is to have 5 million EVs on the road by 2020. China’s leaders want to “leapfrog” the advanced automotive industries of other countries and seize the growing ‘new energy vehicle’ market” (Neve, 2014). The interest in EVs is therefore significant.

Brazil is increasingly passing legislation in favour of electric vehicles, including tax cuts; tariff cuts; and reduced import fees (Smart Cities Dive, 2014). From 2012 until 2017, the Inovar-Auto programme was in use, in which the government encouraged automakers to produce more efficient, safer, and technologically advanced vehicles while also investing in the industry (International Council On Clean Transportation, 2013). After 2017, when the Inovar-Auto policy ends, the EV market is expected to grow significantly with the help of Rota 2030 (the extension of Inovar-Auto), which leads some scholars to believe that Brazil will be the leading market for EVs in Latin America (Barassa, Bermudez, Martínez, Consoni, & Oliveira Filho, 2017). This also indicates its interest in the electric vehicle market.

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Figure 5: Industry Electric Vehicles Index (EVI)4

5.3. Methods

In order to effectively establish the influence of market size on the policy choices of developing countries to acquire technological knowledge, process tracing is used in this research. This entails a detailed, within-case empirical analysis of how the causal mechanism between the market size of the developing countries and the policy choices of these countries plays out. The causal mechanism that has been studied is depicted in Figure 6.

As process tracing is method of investigating within-case causalities, it is important to compare cases to increase the generalisability of the study. For this reason, this study compares two dissimilar cases, as has been explained in the section previously.

4_{Figure obtained from McKinsey (2017), Dynamics in the Global Electric-Vehicle Market,}

Retrieved from: https://www.mckinsey.com/industries/automotive-and-assembly/our-insights/dynamics-in-the-global-electric-vehicle-market

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Figure 6: Process Tracing Causal Mechanism5

The first step is to identify the market size of the two cases that is available to developed countries to sell and produce their products. There are several factors that are of interest when estimating the potential market size of industries: (i) population demographics, (ii) market penetration, (iii) growth rates, and (iv) growth patterns (Acemoglu & Linn, 2004; Murphy, Shleifer, & Vishny, 1989). The population

demographics are of significance, as this indicates the pool of potential buyers of your

product. Earlier on in this paper, the importance of a large group of potential buyers was already established, as it increases the revenues and profits of firms. Demographics of the population, such as income and age help provide an estimation of this potential buyer group (Murphy, Shleifer, & Vishny, 1989). In this paper, GDP per capita is used to provide insights in the population size and their purchasing power (Smarzynska, 2002; Trevino, Daniels, & Arbeláez, 2002). The penetration rate indicates the extent to which a product is successful and adopted in the market. It could also be a measurement of market share, however in this study the penetration rate is measured by the amount of sales of EVs (Acemoglu & Linn, 2004). Another factor to take into account is the growth rate of the market. Previously it was already mentioned that a larger market size indicates greater growth perspectives, therefore the year over year growth rate is also taken into account here. Lastly, this growth rate of past years might help provide an indication for the targets that a country has set for the future, which is where growth patterns are an important indicator. For the first three indicators, the reliance has been placed on retrospective, quantitative data. For the last indicator, the data is based on policy reports that provide a prospective in qualitative data.

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Once the size of the market has been identified, the effects of this size difference on the attractiveness of the market will be explained for both cases. From this attractiveness of the market, the successfulness of FDI attraction is derived. This successfulness will then provide the basis for the policy choice of the developing countries: either use trade policy or use regulatory policies. This is where FDI theory proves to be of use, as this explains the process of transferring technological knowledge to developing countries. Once this has been established, we have come full circle and we can provide an answer to the effect of market size on policy choices for innovation diffusion.

5.3.1. Limitations

Comparative case studies are usually considered a demanding strategy that requires reflexivity and careful consideration before generalizing the results and reflect on the broader implications (Anckar, 2008; Azarian, 2011). Considering the topic of this study, regarding a specific industry, it can be challenging to apply the observations of this study to further policy areas and other industries. In fact, there can be many other relevant variables and externalities in these differing arenas that go against the hypotheses conveyed in this study. Furthermore, the research could hold different effects for other countries, clearly indicating the need for alternative cases.

Inherently, there are some limitations to the use of a case study design. Among these limitations are factors such as researcher bias, difficulty of generalisability, land ack of rigour in sampling. However, acknowledging the limitations regarding the comparative method, the choice for a dissimilar design is also useful in the broader scope of differing industries and policy areas, but also still help to ascertain a causal mechanism between cases with parallels on meaningful characteristics of the study. Another limitation lies in the language proficiency of the researcher with reviewing certain policy documents and scholarly articles, as some of the documents that have been used originate from Chinese. Luckily, there is increasing academic attention for this topic and many English translations exist from several research institutes, which make up for this language barrier.

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6. Availability of Data

This section will briefly touch upon the sources of data that have been used in this research. The different steps in the process will be discussed separately for structural purposes.

6.1. Market Size

6.1.1. China

Information on the market size of China is mostly gathered from two different sources: (i) the China Association of Automobile Manufacturers (CAAM), (ii) government documents, and (iii) from several international (research) institutions, with a primary focus on the data of the CAAM. The reason for using this combination of sources lies in the trustworthiness of the data. Cross-referencing the available data increases the legitimacy of the data and provides a stronger basis for analysis.

The CAAM is a non-profit social organisation that has has the qualifications of a legal social organisation, originated in Beijing in 1987. The ambition is to safeguard the interest of the whole automotive industry, and more specifically the Chinese automotive industry, with implementation of national principles and policies, reflecting the aspiration and demand of the industry while also maintaining mutual service for the government and the industry. Its main functions regard “policy research, information service, self-discipline in the trade, international communication and exhibition service” (China Association of Automobile Manufacturers, 2013). In the end, promotion of sounds and rapid development of the automotive industry is key. The CAAM also has a strong relation with the International Organization of Motor Vehicle Manufacturers. This source proves most of its use in the market penetration, where we rely on sales numbers.

The second source category that is used to measure market size is government documents. Especially when it comes to determining growth patterns, these documents provide insights into the aims and policies of the government that enable the EV industry to grow. Documents from research institutes form the last type of source to evaluate market size. Similar to the government documents, these reports provide insights into the growth rates and expected patterns of growth that the EV

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A combination of qualitative and quantitative data is taken from these sources. Where the retrospective sales information is taken from annual reports, making the sources quantitative, the growth patterns are prospective and are interpreted from policy documents. This information is then described as qualitative data.

6.1.2. Brazil

In the case of Brazil, the information on the market size is mostly gathered from the following two source categories: (i) the Associação Nacional dos Fabricantes de Veículos Automotores (ANFAVEA) with the additional reinforcement from (ii) reports from (research) institutes and academics. Again, data triangulation provides validation of data through cross verification, which strengthens the results.

The ANFAVEA is Brazil’s national association of automotive manufacturers. Among its main attributions are: studying industry and market themes of automotive vehicles; coordinating and defending the collective interests of associated companies; participate, sponsor, and support events and exhibitions linked to the industry on an institutional basis; and compile and disseminate industry performance data (Associação Nacional dos Fabricantes de Veículos Automotores, 2018a). Over the sixty years that the association has been active, it has invested heavily in the creation of factories, vehicles, and new technologies. It produces annual reports with sales and production related figures regarding the automotive industry. Hence, it is useful to read these reports and make up the market penetration and growth patterns.

The extra reinforcement of these numbers have been provided by articles and reports from academics and research institutes, which provide information on the growth patterns for Brazil as the ANFAVEA does not provide any visions into future growth opportunities.

6.2. Attractiveness of the Market

The framework for market attractiveness has already been provided in the theoretical framework (section 3.2.2), where has been established that greater market size leads to greater attractiveness which in turn leads to more FDI. As this logical sequence has already been explained, there is not need for additional data to establish this factor.

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6.3. Effectiveness of Trade Measures on FDI

In order to establish the trade measures that China and Brazil use to force production to their country, a combination of three source categories has been used: (i) reports from the Organisation for Economic Co-operation and Development (OECD), (ii) academic literature, and (iii) reports from research institutions.

The reports from the OECD are mostly used to establish the nature and definition of the specific trade measures of both cases. The OECD’s mission is “to promote policies that will improve the economic and social well-being of people around the world” (OECD, 2018). They do this by looking at issues that affect everyone’s lives and recommend policies for improving the quality of life. This makes it the ultimate institution to accumulate this information from. The reports were electronically retrieved from the OECD database. The further sources within the academic literature and the institutional reports serve to provide the specific policies and numbers that are in place. For all documents, the aim was to use the latest available data; the result is the latest data that was available to the researcher.

7. Market Size

Having discussed the research design and the availability of data, it is not important to explain in detail how these two cases relate to the topics that have been discussed. The following chapter elaborates on the different steps of the process tracing mechanism, providing an overview of the decision-making process of developing countries in their quest to innovate. The first step is to gauge the market size of each case and link it to the respective attractiveness of the market. This is followed by an overview of the effectiveness of the corresponding trade measures that each county has in place to obtain technological knowledge and keep it in the country. Lastly, it is discussed how these differing trade measures influence the decision of manufacturers to invest and how this relates to the policy choices of innovation lacking countries to attract the much needed FDI.

7.1. Population Demographics

7.1.1. China

China’s potential buyer’s pool is very large, with a large population, significant Gross Domestic Product (GDP) per capita, and a government pushing sales. On this day,