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72 CONFLICT AND COOPERATION System Integration and System Friction: New Challenges in Trade Policy The creation and nurturing of hi=,h-technology industries presents a spe- cial case for policymakers in several respects. . First, for the reasons outlined above (see Box A), policymakers in industrial and newly industrializing countries are persuaded of the benefits of encouraging the development of high-technology industries within national borders. The drive to acquire competency in enabling technologies and to diffuse this knowledge throughout the national economy is an objec- tive shared by policymakers throughout the industrial world. Second, many of the practices inherent in national innovation systems are deeply rooted in national economic systems, and reflect long-standin;, government support for programs and practices. For many years, these policies were considered to be "within the border,' that is, within the juris- diction of domestic policies and not subject to international review. Indeed, the inclusion of what were formerly considered to be domestic policies in the GATT negotiations was a major source of contention in the Uruguay Round.~78 During the 1980s, national and regional policies to encourage high-tech- nology industry played a major role in the increased international trade conflict centered on high-technology systems such as aircraft, superconduc- tors, and telecommunications products; technology-intensive products such as automobiles and steel; and key components such as semiconductors and machine tools. The Airbus dispute was primarily over direct subsidies. Other disputes on high-technology sales encompassed public procurement, market access through trade and investment, and standards.~79 DIRECT AND INDIRECT SUBSIDIES Government subsidization of advanced technology has evolved quite sub- stantially in the last twenty years. The classic industrial policy of providing direct financial support, usually in the form of grants, to national champions i78 See Sylvia Ostry and Richard Nelson, Techno-Nationalism and Techno-Globalism, p. xviii and passim. The pervasiveness of the trade negotiators' agenda is such that it includes recommendations for principles and processes central to the state. In the case of China, it is argued that the absence of a transparent, enforceable, and enforced "rule of law" is incompat- ible with the obligations and requirements of the international economy. See Ostry, "The Post Uruguay Trading, System: The Major Challen;,es," Industry Canada Distinguished Speakers Series, Ottawa, pp. 23-27. 179 Sylvia Ostry and Richard Nelson, Techno-l!lationalism and Techno-Globalism, p. 62.

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SYSTEM INTEGRATION AND SYS TEA] FRICTION 73 or industries facing severe international competition has declined, partly due to international pressure. In countries as diverse as Germany and Japan, policymakers grew increasingly skeptical of the open-ended nature of direct support, arguing that it was expensive, ineffective, and often counter- productive. A In its place, governments increasingly provide broad support for core technology activities designed to improve the competitiveness of whole sec- torsi8i (though in smaller economies, the distinction between sectoral sup- port and support for individual firms is often moot). Instruments include cooperative government research contracts, government procurement (de- signed to provide contracts which encourage the application of cutting-edge technologies)' and in some countries government-funded venture-capital mechanisms, e.g., the Japanese Key Technology Center or the U.S. Ad- vanced Technology Program. As noted in Box B. other more traditional and widespread instruments of intervention include direct ~rants, loan guar- antees, equity participation, targeted tax incentives, and R&D infrastructure enhancement, plus many other sectoral and regional supports. In part as a result of U.S. pressure to strengthen GATT disciplines over government subsidies, the Uruguay Round produced an agreement on Sub- s~dies and Countervailing Measures (SCM). However, this agreement pro- vided specific exemptions for "basic" and "applied" industrial research.~83 This agreement has been the source of some controversy, both with respect to its definitions and because many trade practitioners fear it may be a i80 U.S. Technology Administration, Key Foreign Irldustrzal Competitors, p. 1. This U.S. government report describes the evolution and current policies of Japan and Germany for the promotion of the competitiveness of their firms through the use of government R&D funds- policies by no means unique to Japan or Germany. Al Ibid, pp. 2-3 i82 As noted in Box B. the OECD has made a sustained effort to develop a database on government policies and instruments in support of industry. The OECD data suggest that, overall, levels of support for industry are declining but the sectoral concentration is increasing, with 350 new programs in the period 1990-1993. Effective use of the subsidy notification process under the new WTO Agreement on Subsidies and Countervailing Measures should lead to an even more thorough inventory. Even "normal" government support for infrastructure, such as testing facilities, can result in competitive advantage in international competition for high-technology equipment. The possession of a French government-funded testing facility for clystron technology was described as determinant in the award of a U.S. Department of Energy contract to a French firm (also 50 percent owned by the government). See the state- ment by Derrel De Passe, vice president of Varian Associates, to the Symposium on Interna- t~onal Access to National Technology Programs, 19 January 1995. 183 As in any trade negotiation, objectives differed. Partly as a result of the experience with Airbus, as well as in other sectors, the United States sought to strengthen GATE disci- plines over government subsidies while preserving the maximum flexibility for U.S. countervailing duty laws. Other active participants in the GATT subsidies negotiations sought the opposite. Council on Competitiveness, Roadmap for Results, p. 79.

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74 CONFLICT AND COOPERATION source of substantial abuse.~84 Subsidies by themselves, especially devel- opmental subsidies, are usually not first-order trade problems. Their impact is magnified and internationalized, however, when subsidies are integrated into a national policy of market protection and export targeting,. Agreement on the definition of basic and applied research is likely to prove difficult because the current Subsidies and Countervailing, Measures text does not reflect current research practice. According to critics, the GATT text adopted a simple conceptualization of technological chance, namely "that of representing the process as a sequence of several indepen- dent stages consisting of basic research, applied research and invention, market experimentation and commercial innovation, and lastly the diffusion of new methods and products throughout the economy...This simple linear construction ignores the wealth of empirical research at the microeconomic level which shows that technological change does not process unidirectionally through this sequence; it is a far more complicated dynamic process"~85 This distinction is relevant in terms of understanding both the innovatio process itself and the inadequacy of formalistic definitions for the regula- tion of national technology programs. A recent National Research Council report, though not directly concerned with GATT definitions, nonetheless underscored the inadequacy of the view inherent in the GATT text. The report notes that while some projects are clearly basic research and others clearly applied research, the discovery process often does not respect these simple categories. "Research and de- velopment are not separate, serial activities, but parallel and interdepen- dent."~86 The flow of people, knowledge, and know-how between publicly- and privately-funded research organizations goes in both directions. Which direction in any instance depends on the industrial sector, the scientific discipline, and the type of work. Moreover, the report observes that a more severe definitional problem arises from the fact that in the United States "most federally funded research is at once both applied and basic."~87 As an illustration, the report notes Nolan Ramsey's Nobel Prize-win- ning work in physics, which was seminal for the development of the atomic clocks that provide timing and ranging signals key to the operation of the Global Positioning System. The development of the GPS and its associated technologies resulted from the applied research carried out by the U.S. Air Force to create a targeting and navigation system. Following the 1983 184 Sylvia Ostry and Richard Nelson, Techno-Nationalism and Techno-Globalism, p. 60. i85 Paul David and Dominique Foray, STI Review, p. 17. See also Robert White, U.S. Technology Policy, pp. 3-9. The author points out that in some cases, such as the airplane, the technology preceded the science. P. 3. 186 Allocating Federal Funds for Science and Technology, p. 79. 187 Ibid., p. 77.

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SYSTEM INTEGRATION AND SYSTEM FRICTION 75 decision to make the GPS signal available to the private sector, substantial industry investment in research and development created an array of pro- ductivity enhancing information products. Private sector product develop- ment also reduced costs and improved performance dramatically, opening the way to important new civilian applications while also contributing to increased technical capability and availability of military systems. In light of this complexity, in terms of both the research process and goals, the report reasons that a simple distinction between basic and applied research is often difficult to make and rarely decisive in defining the gov- ernmental role.~89 The lack of consensus regarding the specific approach and terminology of the Subsidies and Countervailing Measures Agreement will make its provisions for exempting R&D subsidies extremely difficult to apply. Definitional difficulties for the current exemptions for R&D and the environment are therefore likely to become a source of interna- tional controversy. International initiatives to refine definitions and advise on disputes are unlikely to prove satisfactory. More fundamentally, however, the decision to provide an exemption for R&D subsidies was unwise and should be revisited. This is not to suggest that government R&D subsidies are necessarily improper. But where such subsidies distort international trade and cause injury, they should remain actionable. No reliable definition exists to separate "good" from "bad" subsidies. That being the case, the pre-Uruguay Round rule- that subsidies, of whatever type, are subject to trade action when they cause injury-provided an effective and serviceable test. Of course, governments facing the possibility of trade action may nevertheless, and quite correctly, determine to subsidize the development of new technologies. The case for elimination of approved categories of subsidies is a strong one. First, state aid is fungible because money is fungible. Grants given for research may substitute for private funds otherwise available for that purpose. Private funds can then be freed up for applied research-or for the payment of wages or expansion of capacity, for that matter. Likewise, a $300 million grant to help comply with antipollution regulations can be used to pay wages. For the pre-1994 GATT, the question was not whether a subsidy bore a particular label, but what its effect was. Export subsidies were prohibited because they were considered to be, per se, a distortion of i88 For an overview of the development of the Global Positioning System, see Supplement D. The National Research Council report Allocating Federal Funds for Science and Technol- ogy also cites the case of optics, one of the oldest fields in physics Thirty or forty years ago, it was hard to see applications beyond lens design for cameras and telescopes With the discovery of the laser and its application in fiber-optic communications, optics has turned out to be essential to modern telecommunications networks." Pp. 7~77. t89 Ibid., p. 76.

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76 CONFLICT AI1D COOPERATION trade flows. Other subsidies were susceptible to an offset by other coun- tries if they were seriously prejudicial to that country or injured the latter's industry. The creation by the Uruguay Round of a safe harbor for subsidies depending on what they are called was, in fact, an unnecessary and retro- grade step in the long attempt with GATT to reduce trade distortions. It was the result of a lesser concern with regulating subsidies than with the efficacy of countervailing measures. NATIONAL SECURITY AND DUAL-USE TECHNOLOGIES A further source of complexity regarding the role of government in sup- porting new technologies derives from their increasingly widespread mili- tary applications. The United States like Japani90 believes its national security is based on having guaranteed, cost-effective access to the world's best technology. For many years, the U.S. Defense Department funded research and procured from specialized defense suppliers, and was often successful In sustaining both the technology and the production base at the leading edge. The spread of what were formerly defense-only technologies has made this approach outdated.~9~ Defense-only procurement cannot take advan- tage of the economies of scale derived from high-volume commercial pro- duction, nor can it keep pace with the rapid technological innovation of highly competitive commercial sectors. To benefit from the technological dynamism and the lower costs of commercial production, U.S. policy now is to use commercial components, technologies, and subsystems whenever possible. i92 Under this dual-use strategy, defense initiatives will seek to create or nurture globally competitive domestic industries able to meet defense requirements by drawing on the commercial technology base.~93 (See Supplement C.) This strategy does not exclude international cooperation. On the con- trary, a recent Academy report argues that tight defense budgets and the i90 Richard Samuels presentation to the conference Sources of International Friction and Cooperation in High-Technology Development and Trade, 30-31 May 1995. See also Samuels, Rich Nation, Strong Army. 191 For a cogent summary of U.S. dual-use policy, see Paul Kaminski's presentation to the conference Sources of International Friction and Cooperation in High-Technology Develop- ment and Trade, 30-31 May 1995. For a discussion of the challenges to current U.S. policy, see the presentation of Jacques Gansler, ibid. i92 Flat Panel Display Task Force, Building U.S. Capabilities in Flat Panel Displays: Final Report, October 1994, p. I-2. t93 Ibid.

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SYSTEM INTEGRATIOIV AND SYSTEM FRICTION 77 increased use of commercially derived products suggest that Japan's tech- nological capabilities can increasingly contribute to common security needs.~94 A key principle of the U.S. approach is that any dual-use initiative must be consistent with obligations under the WTo.~95 Nonetheless, the conver- gence of military need and commercial military capacity opens the door to widespread use of national security exemptions for national programs of support to industries deemed critical to national defense. DISCRIMINATORY PUBLIC PROCUREMENT Public procurement remains a major means of government support for national industries and a source of friction in the international system. Because a significant share of markets for high-technology products is derived from public purchases of power generation equipment, telecommu- nications systems and components (switches, fiber optic cable), large high- speed computers for education and national defense needs, and of course civil aircraft, competitive access to procurement markets is important for producers of high-technology equipment. The markets are large, and orders often involve significant follow-on business and can generate significant economies of scale.~96 Public procurement of high-technology products has sparked trade disputes on purchases ranging from those of Airbus aircraft by national airlines to those of telecommunications equipment by national service providers in Europe, sonar mapping, equipment in the U.S., and computer equipment In Japan.197 Notwithstanding the attempts of the GATT to extend the reach of national treatment to public purchases, progress in opening public contracts 194Maximizing U.S. Interests in Science and Technology Relations with Japan, National Research Council, p. 3. To realize this cooperation, however, some adjustment in the asymme- tries In capabilities and institutions for technology and industrial development will be neces- sary. The report notes that "these disparities have led to different preferences regarding cooperative mechanisms, with the United States in most cases preferring off-the-shelf sales of U.S. weapons to Japan, and Japan mostly preferring indigenous development." P. 4. The report identifies two reciprocal problems (which in fact capture the differing, approaches of the two ;,overnments): for Japan, the report cites the "unwillingness of Japanese industry and government to cooperate technologically on reciprocal terms." For the U.S., the report identi- fies "the lack of consistency and coordination in U.S. government approaches" to attempts to obtain more balanced technology flows in defense technology collaboration over the last fif- teen years. Pp. =5. 195 Flat Panel Display Task Force, Building U.S. Capabilities in Flat Panel Displays, p. I-2. 196 Bernard M. Hoekman, and Petros C. Mavroidis, Policy Externalities and H~gh-Tech Rivalry: Competition and Multilateral Cooperation Beyond the WTO, OECD, Paris, October 1995,p. 18. 197 Ibid., and Laura Tyson. Who's Bashing Whom? passim.

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78 CONFLICT AND COOPERATION to intrare~ional and international competition has been slow.~98 Impedi- ments include the complexity and diversity of national and subnational pro- curement, differences in market structure, and a reluctance by officials (at the national, regional, and local levels) to transfer funds to foreign entities to the disadvantage of national producers. Governments still continue to see public procurement as a means of supporting, national champions through noncompetitive contracts. In some cases, contracts are structured to pro- vide the financial resources to undertake additional research in product development. Lucrative home-market contracts can also enable firms to compete aggressively on price in third markets. Discriminatory contracts can and do have important negative effects, not only within the trading system, but within the "protected" national economy as well.~99 The competitiveness of downstream users of the goods and services thus procured can be constrained by their lower quality and perfor- mance, especially in relationship to the global market. Despite these ineffi- ciencies, given the importance of government acquisition in high-technol- ogy markets, international disputes are likely to intensify (see Supplement E). The disputes arising, from these noncontestable national markets are also likely to undermine the conditions necessary for international coopera- t~on in the development of new technologies. Fundamentally, a reexamination of the way the multilateral trading sys- tem addresses government procurement is now necessary.200 In the after- math of the Uruguay Round agreement, government purchases are one of the few areas not covered in a thorough manner by international trade disc~- plines. To a large extent, this is because the existing Government Procure- ment Agreement (GPA) requires its signatories to make the leap to full national treatment in government procurement, a leap that most countries remain unwilling to make. The alternative- described in Supplement E would adopt the GATT tariff reduction procedures as a model that could be applied to achieve steady market-access improvements in the government procurement area. Under this approach, all WTO contracting parties would be members of the GPA, and all government-owned entities would be cov- ered by the disciplines of the agreement. GPA members would be allowed to give preferences to their domestic suppliers as long as they bind them i98 This discussion draws from the presentation of R. Michael Gadbaw to the conference Sources of International Friction and Cooperation in High-Technology Development and Trade, 30-31 May 1995 and Richard E. Baldwin, The Role of Government Procurement, 21 November 1995 contribution to Steering Committee deliberations. 199 Richard E. Baldwin, The Role of Government Procurement. Notwithstanding, govern- ments continue to use targeted national procurement as a means of nurturing high-technology industry. See Supplement E below. 200 For a more detailed review of potential reforms to the Government Procurement Agree ment, see Supplement E.

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SYSTEM INTEGRATION AND SYSTEM FRICTION 79 selves not to reduce their level of openness to foreign competition. Further commitments to regular negotiations to improve the degree of procurement liberalization could be sought, and current GPA procedures could be main- tained, but simplified. Retaliation, where authorized pursuant to a dispute settlement panel ruling, should be permitted through withdrawal of conces- sions made in any of the WTO agreements, not just the GPA, and the fundamental principle of the new agreement should be most favored nation (MEN) treatment rather than national treatment. The fundamental issue, however, is this: increased international cooperation must imply more transparent and competitive procurement regimes. Reserving markets for national champions is ultimately incompatible with cooperative efforts to develop new technologies. This is especially true when firms benefiting from protected home markets seek access to the publicly financed technology development programs of other countries. International contestability of participating firms' home markets may increasingly become ~ de facto condition for coop- erat~ve activity. PRODUCT STANDARDS Product standards raise similar issues. Discriminatory or exclusionary standards practices are incompatible with efforts to improve international cooperation in the development of new products. At the same time, interna- tional cooperation is an excellent means to avoid conflict over differing national standards for key technologies, especially when the cooperative standards-se/tint, is accompanied by improved transparency and mutual rec- ognition. In this regard, the call by the Trans-Atlantic Business Dialogue for negotiations on a full and complete mutual recognition agreement for medical devices, telecommunications terminal equipment, information technology products, and electrical equipment, as well as a common registrations dossier for new drug products, is an important new initia- tive that should be supported.20i 20i Trans-AtZantic Business Dialogue: Overall Conclusions, p. I.1. In the general remarks, the business leaders emphasized that the trans-Atlantic marketplace can flourish only against a background of political cooperation and trust. Treating the policy issues associated with high- technology competition and cooperation is an essential part of this dialogue. See, for example, the calls for greater cooperation in information technology, competition policy, government procurement, and common eligibility for R&D programs. Passim. For a thorough review of the standards issue, see Standards, Conformity Assessment, and Trade into the 21st Century, National Academy Press, Washington, D.C.. 1995.

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80 CONFLICT AND COOPERATION DUMPING AND ANTIDUMPING In the imperfect competition of international trade in hi,h-technology products, most countries have developed trade laws to counter anticompetitive practices of foreign firms.202 Indeed, the nature of hi;,h-technology compe- tition, particularly the possibility of achieving decisive advantage through strategic dumping, makes this practice attractive, especially to new market entrants. The issue is further complicated insofar as some instances of "forward pricing" down the learning curve can legitimately be treated as dumping and counteracted where imports cause material injury to a domes- tic industry in the importing country. In principle, "forward pricing," occurs when a firm prices below current costs in anticipation of generating suffi- cient demand to push actual costs below a price target.203 Yet within the GATT system and the national laws implemented consistently with that system, dumping is selling below fair value, usually considered to be the home market price.204 Strategic dumping differs from "normal forward pricing" in that it usu- ally involves subsidizing exports through domestic prices which are signifi- cantly hitcher than world market prices; it is made possible by collusive price behavior among domestic firms and restricted access to the market by competitive foreign producers.205 Market closure may result from structural differences in industrial organization, access to capital, and corporate gov- ernance (e.g., stockholder expectations), as well as public and private re- strictions on imports and investment.206 In combination, these factors pro- vide both solid protection and powerful incentives for firms to seek foreign market share. Many antidumpin=, cases brought in the 1980s defined dumping not as selling below home market price or discriminating on price in different markets, but as selling below a constructed measure of average production 202 For an informed discussion of the rationale, limitations, and policy dilemmas of this controversial issue, see the section on "Subsidies and Dumping: What They Are, Why They Matter" in Competing Economies: America, Europe and the Pacific Rim, Office of Technology Assessment, Congress of the United States, Washington, D.C., 1991, pp. 138-154. 203 Bernard M. Hoekman, and Petros C. Mavroidis, Policy Externalities and High-Tech Rivalry, p. 16. See also Michael Borrus and Jeffrey A. Hart, "Display's the Thing: The Real Stakes in the Conflict over High-Resolution Displays," Journal of Policy Analysis and Man agement, vol. 13, no. 1 (1994), pp. 50-54. 204 Laura Tyson, Who's Bashing Whom? p. 267. 205 Ostry, "Technology Issues in the International Trading System," p. 10 206 Differences in industrial structure, expectations of capital markets, and management objectives, such as shareholder value versus market share, can result in major differences in firm behavior, in particular the willingness to tolerate sustained losses for market share. See Robert Denham and Michael Porter, Lifting All Boats.

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SYSTEM INTEGRATION AND SYSTEM FRICTION 81 cost.707 Both methods are provided for in the GATT system and have been since its inception in 1947. Given the significant scale and learning econo- mies that characterize high-technology industries (i.e., prices fall as output increases), there are strong incentives for producers to set prices on the basis of a future cost they hope to achieve as they increase production. National ant~dumpin~ laws may reach certain pricing behavior by foreign suppliers provided, again, that imports are causing material injury to a domestic industry even though similar strategies remain available to domestic producers.208 In technology industries characterized by scale and learning economies, forward pricing strategies are indistinguishable from predatory pricin~.209 Thus, there is no basis for requiring that a dumping complaint demonstrate predatory intent, which is notoriously difficult to prove. In addition, the time required to process antidumping complaints is already the subject of legitimate concern in high-technology industries with short product life cycles. Administrative delay in rapidly evolving product markets can permit for- eign producers to move on to the next product cycle before a finding is made. The high cost, rapid innovation, and short product cycles character- izin=, these industries make possible significant damage to domestic indus- try in relatively short periods. 207 For analysis of this and related issues, see Laura Tyson, Who's Bashing Whom? pp. 267-272. 208 Ibid., p. 269. 209 Ibid., p. 268. The author reviews both the rationale of and the problems with national antidumping policies, but rejects the argument that dumping, should be restricted to its original definition of selling goods for less than the home market price. She argues that it would be "both politically unrealistic and economically imprudent" to do so. She states further that "it would be imprudent to overlook the real possibility of pricing below marginal cost as a preda- tory business tactic, and one that is especially attractive in hi~h-technology industries.'' 210 Ibid., p. 271. Some analysts argue that, while there is room for improvement in the current application of antidumping measures, the area where reform is more urgently needed is in making antidumping measures more efficient. In high-technoloay competition, procedural delay can be the equivalent of denial. See Thomas Howell, "Dumping: Still a Problem in International Trade," in Trade and Competition Policies, Westview Press, Boulder, Colo., forthcoming. See also the section "Delay and Uncertainty in Imposin', Duties," in chap. 4 in Competing Economies, Office of Technology Assessment, p. 143. all For example, in the depressed 1985-1986 market for DRAM s, Japanese companies waged an aggressive and arguably successful price war in the United States and other markets. "This was one of the major factors behind the exit of seven out of nine American DRAM producers by 1986" and the domination of the market for the latest generation of DRAM chips by Japanese producers. Laura Tyson, Who's Bashing Whom? p. 101. The vertical integration of the Japanese firms and their keiretsu linkages provided access to relatively cheap and patient capital, enabling them to finance large, countercycled investments and to sustain mas- sive losses. Ibid., p. 100. It is estimated that U.S. firms lost $2 billion during this period and Japanese firms some $4 billion. However, by the end of 1986 the Japanese fibs had acquired a virtual monopoly in a key input for all the systems applications in which they were trying to become significant competitors. Ibid., p. 101.

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82 CONFLICT AND COOPERATION BOX G. TtlE DUMPINGJANTIDUMPING POLICY DEBATE A note is in order on the great divide existing between participants in the debate over the appropriateness of the current WTO/GATT regime of measures approved to counter dumping. The subject is a contentious one. In the United States, Europe, Canada, and Australia all of which have strong Western legal traditions there is in each country a domestic division between, in one camp, those in industry and govern- ment trade agencies who have experience with injury caused by dumping as defined by international agreement, and, in the other camp, academic economists and national competition authorities who vigorously object, on theoretical and philosophical grounds, to the applications of antidumping measures as an unwarranted interference in the market. Within this second camp, there are also economists and policymakers, more attuned to the realities of international competition, who nonetheless object to certain aspects of current practices, without however, rejecting the economic and political considerations on which antidumping actions are based.2'2 There is a sharp intellectual divide on the issue, partly because the natural constitu- encies and assumptions of The two camps differ immensely. The divide separating the two camps occurs in large part because the first proceeds on the basis of experience and a policy construct designed to address important, sometimes conflicting, national economic goals, while critics rely on economic theory, and see firms petitioning for relief as rent seekers fleeing the rigors of international competition. The first group, that is, the industrialists and the trade policy practitioners, are much more concerned with the consequences of dumping on the current health and future prospects of the national industrial base. This includes associated industries, employment and more broadly the technological capabilities that advanced industries bring to the national economy.2'3 This group Is also concerned with the political consequences of rapid declines in the fortunes of major industries. For the most part, the trade policy group has not sought theoretical support for its position. However, it now finds a growing theoretical literature on strategic trade which catis attention to the strategic or critical nature of certain industries These theorists argue that the targeting of specific industries under the conditions of techno- logical externalities, increasing returns to scale, and imperfect competition can lead to 212 See, for example, Laura Tyson's discussion, Who's Bashing Whom? pp. 267-272, noted above. The United States, of course, is by no means the only country having administrative practices which are subject to international criticism. 213 The loss (or acquisition) of industrial capability can have important long-term conse- quences for the national economy. An innovative, rapidly growing industry, and its supporting infrastructure, can be a source of powerful advantage in the international industrial competi- tion. Some analysts observe that technology develops along a path in which future opportuni- ties quite logically grow out of the research and production undertaken today. The pace and direction of technological innovation and diffusion are therefore shaped by current mastery of production processes and market position. In this view, production costs and technology do not automatically converge amon,, nations; they may diverge with important long-term com- petitive consequences. See Steve Webber and John Zysman in Borrus et al., The Highest Stakes, pp. 1?9-180 and note 33.

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SYSTEM INTEGRATION AND SYSTEM FRICTION 85 Moreover, the higher returns which may accrue to national firms benefit- ing from these practices can provide the resources to fund additional re- search, more rapid product development, expanded marketing, and overseas acquisitions of competitors. Even when practiced for relatively short peri- ods, these strategies provide substantial competitive advantage in hi~h-tech- nolo:,y markets. For the recipients of dumped products, the revenue losses from reduced exports and domestic market share are compounded by the loss of the dynamic efficiency gains (i.e., learning by doing) that character- ize high-technolo=,y industries. The cumulative effect of these practices can permanently alter the terms of international competition by forcing compet- ing firms to exit a product market or by deterring, new entrants.220 In these circumstances, the need for prompt and effective antidump- ing policy at the national level is heightened. This may be a second-best policy solution, but it is likely to prove essential for countries with relatively open markets in high-technology goods.22i From the interna- tional perspective, unilateral national action could be usefully supple- mented by improved consensus and standards on competition policy and its enforcement. MARKET ACCESS: COMPULSORY TECHNOLOGY TRANSFERS AND AEROSPACE COMPETITION In the intense competition for sales of hi~h-technolo~y products in tele- communications, power plants and aircraft, companies from both Europe and the United States find themselves engaged in competition for market share. Product quality, such as performance, reliability, and life-cycle cost, are major determinants of commercial success, but not the only deter- minants. As noted above, discriminatory public procurement practices can 220 Paul Milgrom and J. Roberts, "Limit Pricing Under Incomplete Information," Econometrica, vol. 50, no. 2, March 1982, pp. 443~59. See also Paul Milorom, Predatory Pricing, 1987, cited in Laura Tyson, Who's Bashing Whom? p. 268. Ellen the protection offered by anti- dumping laws may prove inadequate to protect an industry, first because the imposition of duties is slow and uncertain and second. even when promptly applied, these duties may often be inadequate to neutralize the advantage gained by foreign competitors. Competing Econo- mies, p. 143. 921 Ending dumping in U.S. and third-country markets is considered one of the achieve- ments of the Japan-United States Semiconductor Agreement. See Ministry of Foreign Affairs, Japan, Salient Points and Data Related lo the Japan-U.S. Semiconductor Arrangement, Tokyo, February 1996, p. 1. For a fuller discussion of this point and the impact of the agreement, see Supplement A.

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86 CONFLICT AND COOPERATION play a decisive role in the purchase of capital-intensive goods such as turbines, aircraft, and defense-related equipment. Many countries seek concessions, especially for public purchases of aerospace and defense equipment, often called offsets.222 A recent U.S. government report noted that, "in defense trade, offsets include mandatory co-production, license production, sub-contractor production, technology transfer, counter trade and foreign investment."223 The report concludes that, "as the world's preeminent supplier of weapons...civil aircraft and high cost-high technol- ogy hardware, U.S. corporations are highly vulnerable to offset demands" and notes that this practice poses a problem for future economic secu- rity.224 Leading high-technology corporations from Europe face similar demands and risks. The aircraft industry, with its slow production cycle, large unit costs, and long-term maintenance and supply contracts, is a prime example of both this fierce high-technology competition and the growing use of offsets as a means of compulsory technology transfer. The global competition for aerospace exports is increasingly exploited, particularly by the steadily more capable economies of East Asia. Countries such as Japan, China, and South Korea demand production offsets to reduce imports and augment their technological capabilities in the aerospace sector. Agreeing to offsets in order to gain access to Asian and other markets has become a prerequi- site to sales of commercial aircraft. Offsets frequently occur in countries such as China that retain state control of the economy but are frequent in advanced economies as well where this practice Is often facilitated by the 222 The term "offset" is frequently associated with military sales where the costs of weap- ons systems, e.g., airplanes, to a government is reduced, i.e., offset' by a certain amount through work performed in the home country with employment and other spinoff benefits. Both the EU countries and Japan have traditionally required offsets for military equipment; the practice now extends to high-technology commercial contracts. 223 Bureau of Export Administration, Onsets in Defense Trade, U.S. Department of Com- merce, Washington, D.C., May 1996. The report notes that offsets may be direct or indirect. The former refer to coproduction or subcontracting directly related to the exported system; indirect offsets refer to compensation unrelated to the export, such as foreign investment. 224 Statement by William A. Reinsch, Commerce Under Secretary for Export Administra- tion in BXA-96-8, 17 May 1996. The BXA report notes that "the newer offset customers, especially in the Middle East, are seeking to diversify their economies rather than build or maintain a defense industry. Pacific Rim countries such as Singapore, Taiwan, and South Korea are seeking offset deals that include increased technology transfer, particularly in air- craft design, to become self-sufficient in military production and to overcome industrial weak- nesses that are hindering their efforts to compete in the world aerospace market with U.S. and European manufacturers. Japan's policy of co-producing defense items has a similar objec- tive." Bureau of Export Administration, Offsets in Defense Trade, p. 6.

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SYSTEM INTEGRATION AND SYSTEM FRICTION 87 important government role in state-owned airlines and, of course, military aviation programs.225 The aerospace industry thus provides a clear, even stark, example of the stakes of international competition for high-technology industries and the high-wage jobs they bring. A recent U.S. study notes that "commercial aerospace has become a key target industry for many advanced as well as industrializing nations,"226 who have adopted explicit industrial policies to advance this goal. Countries as diverse as Germany, France, Japan, and China believe the aerospace industry has the broad range of spillover effects typical of high-technolo:,y industries. (See Box F.) Accordingly, they seek to learn the organizational and design skills, build the supporting, infrastructure, and acquire the high-skilled jobs and high-value exports that characterize this industry.227 The extent of governmental involvement in this sector, combined with the importance of downstream employment effects and the limitations on the demand for aircraft, suggests that aerospace is a sector that will con- tinue to generate substantial friction. In this regard, international competi- tion for the benefits of a national aerospace industry, especially high-wage employment, captures the conflicting trends towards globalization and national competition that characterize some high-technology industries. 225 A recently announced Japanese effort to develop a new antisubmarine warfare patrol aircraft in the 1996-2000 Midterm Defense Program illustrates the close government involve- ment in aerospace development and may be a source of future U.S. friction with Japan. The Japanese press report notes that "there is a strong possibility that the U.S. defense industry, which is suffering from a sharp decrease in U.S. forces procurement, will try to intrude into the program by influencing the U.S. government and Congress." The Japanese editorial expects `'a debate greater than the one at the time of the FSX." An intriguing feature of the proposed ASW aircraft is that "the aircraft's outer form and size are likely to be similar to those of the twin-engine passenger plane Boeing 737, which are used by local airlines." Tokyo AERA article by AERA Board Member Shunji Taoka, "The Whole Picture of the Domestic Patrol Aircraft Plan," 12 February 1996, pp. 16-18. 226 Randy Barber and Robert E. Scott, Jobs on the Wing: Trading Away the Future of the U.S. Aerospace Industry, Economic Policy Institute, Washington, D.C., 1995, p. 6. Sylvia Ostry, "Technology Issues in the International Trading System," also notes that improving the balance of technology flows is a high priority for a growing number of countries, adding that these national "efforts to induce [technology] inflows and reduce outflows are bound to lead to disputes and also will reduce global welfare" (p. 1 1). This is true. It is also true that there will be winners and losers, i.e., some nations will gain technological capability at the expense of others. Laura Tyson, Who's Bashing Whom? p. 40. 227 Barber and Scott, Jobs on the Wing, p. 6. Similar motivations underpin the proliferat- ing national programs to build indigenous microelectronics industries.

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88 CONFLICT AND COOPERATION BOX H. THE STAKES IN AEROSPACE COMPETITION Aerospace has been identified as a prime target of national and regional industrial policies around the world. A number of these competitors have the goal of developing a full-service commercial aerospace industry China is assembling entire Western- designed jetliners. German aerospace efforts have been consolidated under the um- brella of Daimler-Benz (although the CoSt and commercial challenges of this competi- tion are highlighted by the bankruptcy of Folker) Japan is mounting a systematic effort to become a first-tier aerospace manufacturing power, an approach underscored in a recent National Research Council review of U.S.-]apan technology linkages, appropri- ately entitled High-S~cakes Aviation.228 Even only recently industrializing countries such as Indonesia have joined over third other participants in the global comest for a share of aerospace.229 In Europe, the participants in the Airbus consortium have successfully reestablished a European role in commercial aircraft production. To compensate for the advantages they perceived as accruing to American aircraft producers through years of direct and indirect (primarily military) support, the participating governments provided direct financial and commercial support to their national participants in the consortium. This direct support included government contracts for development, loans and loan guaran- tees on favorable terms, equity infusions, tax breaks, debt forgiveness, and even guarantees against losses caused by changes in exchange rates.~ Overall, the effort to build Airbus involved years of sustained expenditure, with some estimates of the net European investment at about $26 billion.23' in addition, European governments were able to influence procurement decisions of national airlines, through both outright government ownership and regulatory powers.232 This preferential procurement pro- vided the crucial, first initial launch orders necessary to begin aircraft programs.233 This sustained, integrated, regional effort has been a success.234 The Airbus consor- tium is now the world's second-largest commercial aircraft manufacturer and supports 228 High-Stakes Aviation: U.S.-Japan Technology Linkages in Transport Aircraft, National Academy Press, Washington, D.C., 1994. 929 Ibid., p. 87. 230 For a discussion of the complexity of the Airbus accounts, see Competing Economies, Office of Technology Assessment, p. 353. Airbus itself receives no financial support; "the disbursement and repayment of launch aid and other supports is handled among the members and their governments." Ibid. 23 l Gellman Research Associates, "An Economic and Financial Review of Airbus Industrie," 1990, cited in Barber and Scott, Jobs on the Wing, p. 50. 232 Competing Economies, p. 355. 233 Ibid., pp. 35~357. European analysts argue that "cost-plus" U.S. military contracts have provided high rates of return for U.S. aircraft manufacturers on military programs, thereby enabling them to initiate commercial aircraft programs whose risk-adjusted prospective rates of return are below "ordinary" hurdle-rates. In addition, the contract price of military aircraft programs generally includes funding for manufacturing facilities; in some cases, military pro- grams helped defray initial design costs. See H. Landis Gabel and Damien Neven, "In Defense of Airbus Industrie" in Olivier Cadot et al., European Casebook, pp. 178-lgl. During the post-war period, the U.S. commercial aircraft industry also benefited from substantial direct support through NASA and NACA and from indirect financial support through military re- search. See David C. Mowery and Nathan Rosenberg,, Technology and the Pursuit of Eco- nomic Growth, Cambridge University Press, New York, 1989, p. 188. 234 Not all analysts consider Airbus a success. Indeed, by some measures, public costs may outweigh Gains. See, for example, Damiel Neven and Paul Seabright' "European Indus- trial Policy: The Airbus Case.', Economic Policy, no. 21, October 1995. The authors find that,

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SYSTEM INTEGRATION AND SYSTEM FRICTION over 100,000 jobs, with major spillover effects for European economies, especially the development of the European aerospace supply base. Given the success of the Airbus program and the broader benefits to the economies of consortium members, it is riot unreasonable to expect that the prospect of similar success will eventually attract new, state-supported market entrants. Aerospace has become a key target industry for both the advanced and industrial- izing.nations. They seek to acquire the industrial infrastructure and skills associated with "aircraft electronics, advanced metal fabrication, composite materials, turbine engines, and other (aircraft) componems."~5 They recognize Mat aerospace has broad spillover effects and Mat "the organizational skills and discipline to design, fabricate, assemble, market and service commercial a~rcraft"236 are of great national benefit, not only as high-value exports but also as a platform for other high-technology industries. The competition for this sector shows no signs of diminishing in its intensity or in the level of direct government support A recent report by the National Research Council concluded the heightened international competition and dramatic reductions in the defense budget mean the U.S. industry `'will be severely challenged over:the next decade just to hold its current position in global aircraft manufacturing."23' :Other recent reports call fork series of measures to maintain U.S. technological :leadership, revitalize U.S. manufacturing, ensure "a level playing field for international competi- tion," and deve.lc~p "a shared U.& vision".of We indussry.23~ The belie! cilia: meeting this challenge will require government action is widespread. As one analyst observed, "rather than -hope That foreign intervention in the industry will cease' the United States~ w~H'hav:e to r.espond-with offsetting i.n.terventions at home. Crasher than assume that dependence on~foreign ~suppJiers does not :.maner, it will have to recognize tire dangers of excess've.depen.dence on such suppliers for critical compo- nent seehnoic~gies, such as advanced aviortics.',239 ~ This observation was prescient The Japanese government strategy of funding developmer~t costs, as leverage to obtain work-shares and access to leading-edge technologies, has had substantial success.240 As suppliers' of critical subeomponencs- and assen~blies,-the major integrators have become sufficiently dependent on,lapanese firms continued 89 given the prior presence of McDonnell-Douolas, entry by Airbus reduced airline prices only modestly. Hence, they find the consumer surplus argument for government subsidy to Airbus is weak, given the competition already provided by MDD. This analysis undercuts the justifi- cation for government support on consumer welfare grounds. However, it does not address the strengthening of the European aerospace industry, including employment, through the shift in rents from U.S. producers to European producers. See Competing Economies, p. 352. For a consumer-oriented analysis critical of the Airbus program, see Richard Baldwin and Paul Krugman, "Industrial Policy and International Competition in Wide-Bodied Jet Aircraft" in Richard E. Baldwin (ed.), Trade Policy Issues and Empirical Analysis, University of Chicago Press, Chicano, 1988. 235 Barber and Scott, Jobs on the Wing, p. 6. 236 Ibid. 237 High-Stakes Aviation, p. 75. 238 Ibid., p. 5. 239 Laura Tyson, Who's Bashing Whom? p. 211. 240 See Competing Economies, pp. 349-352. The report cites a MITI report which states the need for the government to subsidize aircraft development projects and develop aircraft engineering "on the initiative and the assistance of the government as it involves highly so- phisticated and complex technology." "The Vision of MITI Policies in the 1980s," cited in David C. Mowery and Nathan Rosenberg, The Japanese Commercial Azrc raft Industry Since

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9o CONFLICT AND COOPERATION that Boeing claims it can no longer build an aircraft without the participation of Japanese suppliers.24' Japan has made a similar sustained effort to develop its capability in military aircraft The FSX is now entering service as the F2, representing the successful, if costly, completion of this controversial cooperative program under which some S0,GOO differ- ent technologies were reportedly transferred to Japanese manufacturers by the United States. The joint development program also called for the transfer of leading-edge Japanese technologies to U.S. manufacturers.242 Some reports, noting the aircraft COSt almost twice what she Japanese government expected tO spend' have described the plane as a "sleek, supersonic monument tO the inordinate COSt of 3apan's industrial policy the strategy of entering new industries by subsidizing businesses to develop them."243 Others see this co-deYelopment project-both as a source of momentum for Japan to develop its defense and commercial aerospace industry, and as a source of pressure to ease its ban on: weapons exports in order to gain the economies of scale necessary to make systems like the FSX economically viable.244 Continued U.S. job losses and deterioration in the import-export ratio are causing considerable concern among U.SA aerospace workers. (By some estimates, the com- bined effects of reduced defense :spending and the steepest recession In airline history have resulted in the loss of over 50G,000 aerospace labs in :the last five years.24S3: In this .. . . . , . . ~ . . . environment, pressure for U.S. policy initiatives is mounting, backed by strong labor support with calls:~for lJ S. measures- to counteract foreign industrial policies, such as financial inducement, offset ~agreements, and: subsidies.246 There are also calls to coordinate Up. aerospace policy; promote:aerospace production and employment- not least by the elimination of policies which work against Ups. job creation (e.g.' antitrust barriers permitting U.S. companies to team withy foreign companies, but not with over American companies); and negotiate new international trade agreements, including:: a new crvil aircraft code in the WTO which would ;fc~rbid: offsets. These nascent U.S. efforts to adjust to: the new competitive environment. especially the drop in defense spending, in conjunction with the impact of Me ;ndusuial Polices ocher radons, suggest that Ids area may well be a source of future international Diction. 1945: Government Policy, Technical Development, and Industrial Structure, The International Strategic Institute, Stanford, Calif., 1985. 241 Barber and Scott, Jobs on the Wing, p. 59. 242 See, for example, Steve Glain, "Concern Over 'Menace' Dissipates as Japan, U.S. Unveil Fighter Jet," Wall Street Journal, 22 March 1996, p A1. Critics who note that the Japanese government is paying five times as much for an F-16 as for a plane U.S. experts consider not much more capable miss the point, which is not whether the FSX is successful in terms of the performance of the plane itself though Japanese Air Force officials argue it is superior in important respects. The major Japanese goal in undertaking the project is the mastery of the technologies and systems, e.g., avionics and fire control, and the manufacturing skills necessary to produce an advanced fighter aircraft. Ibid. For a detailed account of the motivations and negotiations surrounding the FSX controversy, see Jeff Shear, The Keys to the Kingdom, Doubleday, New York, 1994. 243 Steve Glain, Wall Street Journal. 244 Ibid. 245 Barber and Scott, Jobs on the Wing, p. 1. The report summarizes research which forecasts a loss of $129 billion in sales to foreign producers between 1994 and 2013, with substantial increases in imports during the same period. The report estimates that, as a result of this increased foreign competition and imports, up to 250,000 jobs in aerospace and related industries are.at risk over the next four years. Ibid., p. 2. 246 Ibid., p. 74.

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SYSTEM INTEGRATION AND SYSTEM FRICTION INTELLECTUAL PROPERTY PROTECTION 91 Most high-technology industries are distinguished by the importance of intellectual property rights for research and discovery of new processes and products. The deployment and exploitation of intellectual property depend on the ability to maintain ownership and control over their inventions. Most industrial countries have developed a comprehensive and sophisticated sys- tem of protecting intellectual property rights (IPR). However, there remain significant divergences among the United States, the European Union, and Japan. This divergence is especially clear in patents where some believe that the U.S. system favors the creation of intellectual property over its diffusion, whereas other systems tend toward greater diffusion of the prop- erty thus created. International calls for harmonization of IPR regimes are likely to increase, although prospects for progress remain uncertain. In addition to efforts at harmonization, intellectual property protection faces two other international challenges. First, there is a need to promote effective worldwide protection of intellectual property rights, particularly in rapidly industrializing countries. Many of these countries have laws designed to protect intellectual property; however, for various reasons, effective enforcement has remained elusive. As a result, hiah-technology industries incur substantial losses in these markets. For example, U.S. industries estimate losses of $2.2 billion in 1995, more than double the $1 billion lost in 1994 as a result of intellectual property theft in the People's Republic of China alone 247 A single CD- ROM illegally produced in China can hold $10,000 of U.S. software and sell for less than $10 in Hong hong. Countries such as Brazil, India, and Korea reportedly have similar intellectual property enforcement problems. Such high-value-added industries as motion pictures and pharmaceuticals are impacted by inadequate enforcement, particularly as the share of their revenues generated by sales in international markets increases. While each country has its own enforcement obstacles, there are common themes. In many instances, particularly in larger countries such as China, it may be difficult to secure cooperation from regional and local officials 247 See Statement of Ambassador Michael Kantor before the Senate Subcommittee on East Asian and Pacific Affairs, pp. =5. See also Scott Williams, 'Anti-Piracy Groups Target China Technology Companies Want Federal Action," Seattle Times, 18 February 1994? p. E1. Intellectual property protection remains at the forefront of the international trade agenda. For example, the U.S. government considers the inadequate protection of intellectual property rights to be one of the most important issues on the bilateral trade agenda with China. Despite progress under the terms of a 1992 agreement creating a sound legal regime for IPP, its enforcement has been inadequate in areas ranging from computer software, motion pictures, and sound recordings to pharmaceuticals and agrichemicals. See Kantor testimony, 7 March 1996, passim.

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92 CONFLICT AND COOPERATION outside the central government. Furthermore, in many countries which pursue a policy of promoting diffusion of technology, lax enforcement serves as an economic incentive that encourages intellectual property theft on a grand, even industrial scale. Some software producers have dubbed certain countries "one-copy" countries, meaning that once a single copy of a pro- ~,ram gets into the country, practically all further copies in the market are illegal copies.248 It is important to note that the problem of illegal copies is not confined to the Chinese domestic market. Mainland pirate producers, transshipping through Hong hong, are exporting illegal copies of CD-ROMs and CDs to markets in Southeast Asia, Latin America, North America, and Russia and the CIS states. Moreover, the problem seems unlikely to dimin- ish as China continues to import CD production lines.249 The second challenge is rapid technological change in high-technology areas such as global information systems and biotechnology. These sectors raise important new issues which may require significant adjustment to existing IPR rules. For example, the global explosion in Internet usage as well as its potential as a channel for the export of ideas and intellectual property raises serious government policy considerations. Internet-related legal issues such as the scope of copyright protection afforded transmitted digital information, as well as the ability of foreign governments to censor information made available on the Internet, are just beginning to emerge on a global basis. At this time, technology appears to have outpaced the devel- opment of existing intellectual property regimes. Even fundamental ques- tions, such as which country's copyright laws should apply the country in which the "client" computer (the purchaser of the information) is located or the one in which the "server" computer (the provider of the information) is located have not been resolved.250 Similar dramatic technological changes exist in the biotechnology field, particularly in the area of genetics. Intellectual property law is being called 248 "U.S./China Make Progress in Talks; Many Industries Urge U.S. Action." Interna- tiorzal Trade Reporter, vol. 12, no. 4, 25 January 1995, p. 168. 249 The U.S. government has identified some thirty-four CD factories in South and Central China, producing some 54 million CDs and LDs in 1995 for a domestic market that can absorb only two to five million. Continued imports of CD production lines suggests that China may soon have the production capability that is close to 200 million CDs. Kantor testimony, 7 March 1996, p. 4. 250 Mark Turner, "Labyrinth of Laws Could Lead to a Net Loss," The Independent, 15 January 1996, p. 11. Recently, a controversial German court decision effectively forced Compuserve, a U.S. Internet access and information service provider, to shut down certain "pornographic" files for all global users because, under German law, such files were illegal. While CompuServe is reportedly preparing a legal challenge, there appears to be no body of law or precedents which will be helpful in resolving the dispute.

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SYSTEM INTEGRATION AND SYSTEM FFlCllON 93 upon to extend traditional patent protection to genes and perhaps labora- tory-created organisms. Hanging in the balance of such disputes are rights to diagnostic tests and treatments for diseases (such as breast cancer), which have a tremendous monetary value. Such advances will require new norms, best achieved through international accords.25~ At the national level, patent holders face substantial hurdles to useful enforcement because of the slow and cumbersome movement of patent litiga- tion. The length and cost of enforcement procedures can, in effect, deny protection to patent holders who lack the resources to defend patent rights. Practices such as "blanket filing" of patents can pose nearly insurmountable problems for small undercapitalized companies. No matter how innovative, small companies cannot afford the protracted legal battles necessary to defend their intellectual property and can therefore be forced to license it. The result is that "a new competitor is created without having the research and develop- ment costs of the original innovator."252 This can mean that the smaller company finds itself at a substantial disadvantage in selling a technology it invented and brought to market.253 In these circumstances, that is, competition between a small innovative company and a large resource-rich multinational with superior capability in litigation, marketing, and distnbution, the financial pressures for accommodation through licensing can become compelling. Even for major U.S. companies, ensuring effective intellectual property protection and meeting the cost of vigilant enforcement can be daunting tasks.254 Indeed, in the late 1980s, even companies as robust as Intel argued 25] Transatlantic Business Dialogue: OveraZI Conclusions, p. II.4. See also Ostry, "Tech- nology Issues in the International Trading System,~' pp. 11-12. 252 A 24 June 1988 letter submitted to the Senate by Intel in support of Fusion Systems Inc. technologies testimony detailing Mitsubishi's efforts to lay claim to its microwave lamp technology, cited in an article by Skip Kaltenheuser in New Technology Week, 5 February 1996, p. 7. The Fusion Systems congressional testimony argued that large Japanese companies are able to manipulate their patent system as a result of the "absence of a strict duty to disclose prior art an absence that precludes any need to demonstrate why the claim in an application represents a true inventive step." Fusion Systems also argued that, because "there is no effectively enforced patent fraud statute," there is "no danger of penalty for applicants...who knowingly copy...technology" and file patents on it. Ibid., p. 3. The 1996 U.S. Government National Trade Estimate report finds that foreign companies continue to face a series of obstacles in trying to obtain effective patent rights in Japan, including narrow claims and patent interpretation, patent-flooding, and a difficult and very slow judicial appeals process' among others. 1996 National Trade Estimate Report, USTR, p. 187. 053 Skip Kaltenheuser in New Technology Week, op. cit. 254 Robert M. White, U.S. Technology Policy: the Federal Government's Role, p. 19. The author cites the defense by Corning Glass against patent infringement by Sumitomo, first in exports to Canada, then directly to the United States, and finally in a U.S. production facility. Corning's defense of its sixteen-year, several hundred million dollar investment illustrates the importance of effective intellectual property protection as well as the need for the resources to execute an effective defense.

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94 CONFECT AND COOPE - TION that patent flooding "makes the standard for competitiveness in Japan a firm's size and ability to fund litigation rather than innovation, productivity and marketing."255 Even if, as some argue, these differences in intellectual property regimes result from different historical development and current national needs, differences over intellectual property norms and enforce- ment are likely to prove a growing source of international friction. Efforts at harmonization of intellectual property protection must strike a balance between legitimate desires for both protection and diffusion. Without ad- equate protection, however, there will be less innovation to diffuse. In addition to work on harmonization, there is a pressing need for sustained international commitment to the protection of existing intellec- tual property rights. At the same time, a cooperative effort should be undertaken to adjust existing intellectual property rules to the needs of new fields such as global information systems and biotechnology. Multi- lateral efforts to address these issues constructively should be encouraged. INVESTMENT INCENTIVES The political attractiveness of investment in high-technology industries and the associated high-wage, high-value-added jobs leads both nation- states and regional subunits into a beggar-thy-neighbor competition, often through generous investment incentives. In the U.S., incentive programs can be grouped into three broad categories: tax incentives, financial aid, and employment assistance.256 These incentives include tax subsidies, infra- structure development, and other incentives, e.g., grants in kind, worker training, loans, and extensive tax holidays. Many American states have adopted industrial policies focused on this locational competition. As a result, "the financial incentives offered by competing States have grown dramatically since the mid-1970s."257 The rapid growth in the locational competition among states and the heavy subsidies this competition engen- ders have sparked calls for federal action. 255 Skip Kalaenheuser in New Technology Week, p. 7. 256 See Chris Farrell in Fettig (ed.), The Economic War Among the States, Federal Reserve Bank of Minneapolis, May 1996, p.1. 257 Multinationals and the National Interest, Office of Technology Assessment, pp. 6~67. The amounts involved in these incentive programs continue to grow. In 1992, the state of Ohio paid $16 million in direct incentives to Honda. (Ibid.) More recently, for a new vehicle production facility, Daimler-Benz reportedly received a total package estimated to be between $250 and $300 million, i.e., nearly as large as the much-debated Advanced Technology Pro- gram of the Department of Commerce. For an analysis of the policy issues concerning the competition among the industrial policies of state governments in the United States, see David Fettig (ed.), The Economic War Among the States.

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SYSTEM INTEGRATION AND SYSTEM FRICTION 95 Those favoring federal action are concerned that the states are engaged in a competition which, in the aggregate, is economically destructive, par- ticularly in an era of limited public resources. Federal regulation in the United States would emulate the role of the European Union, which has sought to impose discipline on the investment incentives offered by Euro- pean member states. These incentives are linked to regional economic conditions and are subject to review under EU jurisdiction over competition policy. Others argue that as cities, states, arid regions increasingly become the locus of competitive advantage, it makes little sense for national au- thorities to limit their flexibility in attracting investment, an argument that can be applied to European nations as well as the American states.258 With respect to the locational competition among American states, some observers have identified an emerging consensus on several aspects of the competition among states (which are not unrelated to international competi- tion). These potential areas of agreement would include (1) the disclosure of the full cost of incentive programs; (2) mechanisms for tracking the performance of public-supported investments; (3) the strategic targeting of investment incentives toward depressed regions; (4) a reduction in public expenditure on multinational corporations and sports franchises; and (5) greater investment in upgrading worker skills to meet the business needs of local entrepreneurs.259 Interestingly, one final area of agreement is noted, namely that "no state can stop using development incentives in a world of fierce domestic and international competition. To do so unilaterally would be politically and economically suicidal."260 This belief is, of course, not confined to the economic competition among American states. Better understanding of the scope of these incentives, and of their aggregate costs and benefits including their impact on decisionmaking at the level of the firm, would be very useful to national and regional policymakers alike. Within national jurisdictions it may be possible to establish norms with legislative underpinnings if required to limit excessive public-private transfers in the competition for new invest- ment. At the international level this subject should be explored as a potential element for inclusion in the negotiations for the multilateral agreement on investment. (See the discussion of national investment re- gimes below.) 258 See Graham S. Toft in David Fettig (ed.), The Economic War Among the States, p. 10. 2s9 Chris Farrell in David Fettig (ed.), The Economic War Among the States, p. 4. 260 Ibid.