Foreign technology, spillovers, and R&D policy

We study the appropriate domestic RED policy in an asymmetric duopoly with R&D rivalry and technological spillovers from the more advanced firm. A ''foreign'' and a ''home'' firm compete over two periods on R&D and output. Initial foreign R&D lowers the cost of home's subsequent R&D improvements. The optimal policy balances the strategic incentive to reduce initial foreign R&D with the spillover incentive to increase it. If discounted home profits increase (decrease) with higher initial foreign R&D-the spillover (strategic) effect dominates-a tax (subsidy) to first-period home R&D is appropriate.