Trade policy in markets with collusion: The case of North–South R&D spillovers

• A North-South competition takes place in the Northern market over infinite horizon.
• Domestic firms set cooperatively R&D, collude and act as price leaders.
• Southern firms may share market with the Northern firms and benefit from spillovers.
• R&D spillovers may soften price competition and lead to monopoly pricing.
• Tariffs may trigger a pricing strategy that drives foreign firms out of market.

It is well known that unilateral R&D spillovers hamper domestic firms׳ incentives to invest in innovations and thus have likely adverse effects for domestic welfare. However, when tacit collusion between foreign and domestic firms is likely, R&D spillovers may encourage monopoly pricing and therefore may have an additional detrimental impact on domestic welfare, especially on consumer surplus. Tariff protection could address this problem by altering firms׳ cost efficiency distribution and, thus, by inducing tougher market competition. Consumers benefit from the tariff policy, and governments that assign a high enough weight to the consumer surplus set positive tariff levels. Under protection domestic firms׳ innovation level remains the same as under free trade but the average industry efficiency increases.