We discuss innovative incentives of a local firm when an advanced technology may be available through a foreign firm. The domestic government follows either protection or free trade policy, but there are uncertainties about the realization of a particular policy. We portray the situations in which licensing, either with or without innovation, occurs in equilibrium. We point out that without a binding contract equilibrium outcomes do not always maximize the aggregate industry profit. Also, negative license fee can occur in equilbrium. This analysis is then applied to the controversial question of whether the liberalization policy generates sufficient incentives for domestic innovation. In particular we show that, under the same parametric situation, an innovation decision can be optimal if a protective policy prevails with certainty, while licensing occurs if free trade prevails for sure. The paper also shows that innovation incentives can be strictly lower where the government cannot commit to its liberalization policy so as not to intervene in case of failure.
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