INTERNATIONAL ECONOMIC JOURNAL Volume 13, Number 2, Summer 1999

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WHY SPY? AN INQUIRY INTO THE RATIONALE FOR ECONOMIC ESPIONAGE* MERRILL E. WHITNEY AND JAMES D. GAISFORD* University of Calgary

Economic espionage can yield desirable strategic effects as well as cost savings for firms in a spying country. The spying country will typically gain even though counter-espionage operations will often be conducted by target countries. When two producing countries spy on each other, it is possible that both will be better off because of the technology transfer which is implicit in espionage. Economic espionage is generally beneficial to consumers. [F12, O031]

1. INTRODUCTION Economic espionage, it would appear, is a increasingly common phenomena. While the clandestine nature of spying precludes systematic empirical verification, anecdotal accounts in the popular media abound. For example, Pierre Marion, former director of the French intelligence services, has stated that: “It would not be normal that we do spy on the (United) States in political matters; we are really allied. But in the economic competition, in the technological competition, we are competitors; we are not allied.” (Security Management, 1992) Similarly, Stansfield Turner, former director of US intelligence has said that: “The United States ... would have no compunction about stealing military secrets to help it manufacture better weapons. If economic strength should now be regarded as a vital component of national security, paralled with military power, why should Amecica be concerned about stealing and employing economic secrets?” (Turner, 1991) Further, a document from France’s Direction Générale de la Sécurité Extérieure (DGSE) that was leaked to a news service (Time Magazine, 1993, June 7) appeared to suggest that some of the most technology-intensive in US firms were targets for French intelligence agents. The DGSE, it seemed, was seeking information on manufacturing processes as well as sensitive information on corporate and government plans. It is often argued that the end of the Cold War has contributed to an increase in economic espionage by releasing intelligence resources. In addition, the perceived need for Western nations to cooperate against a common threat has eased, turning military allies into more vigorous economic competitors. The counter-argument *An earlier version of this paper was presented at the 1994 meetings of the Canadian Economics Association in Calgary, Canada. The authors acknowledge helpful comments and suggestions from J. R. Church, T. Terriff, R. Ware and an anonymous referee. The authors, however, are responsible for any remaining shortcomings of the paper.

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is that the apparent growth of economic espionage may be an overstatement by national intelligence agencies as a ploy to protect their budget allocations. While it is difficult to determine either the extent or growth of economic espionage, there is no doubt that such activity does occur. Why do countries conduct economic espionage? Will foreign governments respond with defensive or offensive intelligence activities of their own? This paper will show that there may be indirect strategic benefits from spying that go beyond the more obvious direct benefits from access to valuable economic secrets. In such situations, economic espionage may shift profits from foreign firms to domestic firms and, thereby, provide an additional channel through which national welfare could rise. Nonetheless, the potential gains of the spying country are indeed limited by the responses of foreign governments and firms. Porteous (1993) and Brander (1997) have sketched the argument for espionage as a form of strategic trade policy. This paper will both formalize and extend the analysis of economic espionage. Consequently, the paper is closely related to work on strategic trade policy by Brander and Spencer (1985), Dixit (1984), Eaton and Grossman (1986), Dixit and Kyle (1985), Branson and Klevorick (1986), and Grossman (1986) and others. Since information plays a vital role in economic espionage, there are also some parallels with the work on information sharing in oligopolies by authors such as Gal-Or (1985) and Vives (1984). Many types of sensitive information may be obtained by means of economic espionage. If spying unearths the blueprints of a product or the source code for software, the fixed costs associated with Research and Development can be reduced for domestic firms. In such a case, there are direct benefits for domestic firms, but no strategic benefits because the behaviour of the domestic firms in global markets will remain unchanged. On the other hand, information on contract bids, marketing plans, or costs of rival foreign firms may give rise to strategic benefits in global markets even though there are no direct benefits. Finally, if the production technology of foreign firms is obtained, there will be both a direct benefit from lower total costs for domestic firms and a strategic effect on global markets due to lower marginal costs. This paper will focus on espionage performed to obtain marginal-cost reducing production technologies. While this paper considers espionage by the government on behalf of domestic firms, the analysis could easily be adapted to allow for spying by the firms themselves. Government spying, however, may have advantages over corporate espionage. National spy agencies may be able to reap economies of scale and/or scope. Further, the information that is obtained by means of spying is non-rivalrous in the sense that it can be used by all domestic firms. Thus, government conducted espionage may yield positive social benefits even if the private benefit of corporate espionage to an individual firm is negative. In a related vein, the government would be able to take the favourable effects of spying on domestic consumers into account whereas this externality would be ignored in the case of corporate espionage. On the other hand, in some countries such as the US the business culture of arms-length relationships between firms and government may make economic espionage by governments more problematic.

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The goal of this paper is to examine the potential for economic espionage within oligopolistic industries where the firms export a significant fraction of their outputs. Throughout the paper, a stylized version of the commercial jet aircraft industry will be used as the backdrop for the discussion. The world industry is highly concentrated, has significant barriers to entry, and is research and development intensive. Moreover, the key firms - Boeing and Airbus - export substantial proportions of their outputs. The commercial jet aircraft industry has been a popular focus for studies concerning strategic trade policy. For example, this industry is central in Dixit and Kyle’s (1985) analysis of the subsidization of fixed costs as a means of promoting entry by a domestic firm. Nevertheless, it should be emphasized that this paper is to be read as fiction. The paper provides a hypothetical, “what if” type of analysis and it certainly does not provide a descriptive account of the actual firms or governments. The basic model that is presented in Section 2 shows the strategic profit-shifting effects of economic espionage in a simple setting. This basic model is elaborated in alternative directions in the three subsequent sections. Section 3 allows one government to engage in aggressive espionage while the rival government undertakes defensive counter espionage. Section 4 models two-way aggressive spying where both governments use their national intelligence service to steal secrets from the rival country’s firm. The concluding section reconsiders the role of economic espionage and its status as a tool of trade policy and technology transfer. 2. A BASIC MODEL OF ECONOMIC ESPIONAGE Except where otherwise noted, we adopt a set of assumptions that are common in the literature on strategic trade policy. (a) In each of two producing countries, France and the US, there is a single firm. (b) The output of each of the two producing countries is entirely exported. (c) The French and American firms, Airbus and Boeing, play a Cournot duopoly game. (d) The firms produce a homogeneous output. (e) The profits of each firm accrue only to citizens of the country in which the firm is located. Since the relaxation of any of these assumptions weakens the case for strategic trade policy (see Eaton and Grossman, 1986, and Grossman, 1986), these assumptions will be discussed further below. We will also impose two additional simplifying assumptions. (f) The demand by third countries is linear. (g) Both firms are subject to constant marginal production costs. The linear demand schedule of the consuming countries is: P = α - β (QA + QB)

(1)

where, P denotes the price, and QA and QB denote the outputs of Airbus and Boeing respectively.

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In all of the spying models that follow, three consecutive events occur as indicated by the time line below. 1

2

Intelligence activity is conducted

Intelligence results are revealed

3 Airbus versus Boeing Cournot duopoly game

In the basic model that is developed in this section of the paper, Boeing possesses an exogenously given secret technology and France can engage in economic espionage to attempt to obtain that technology for Airbus. For the moment, the United States government is assumed to be passive. ASSUMPTION 1.0: The firm in the target country possesses a single, discrete and indivisible secret technology that reduces its marginal cost below that of its rival. Thus, the timing of this game is such that France engages in spying, then the success or failure of espionage is revealed, and finally the firms play a Cournot duopoly game. 1 Since France anticipates the subsequent play of the full-information Cournot duopoly game when it makes its investment in espionage at the outset, the model must be solved backwards. A. State-Contingent Cournot Duopoly Sub-Games We let x denote the “penetration rate” or probability that French agents successfully penetrate Boeing and acquire the new technology for Airbus. Thus, the probability of state one where French agents fail to penetrate Boeing is 1 - x, and the probability of state two where they succeed is simply x. Given that the marginal cost attainable with previous-generation technology is θ and the marginal cost reduction attributable to the new technology is σ, Airbus’ marginal cost is θ in state one, but it falls to Boeing’s level of θ − σ in state two. Routine calculations for each of the two states yield the Cournot-Nash equilibrium outputs, profits and consumer surpluses that are shown in Table 1. Boeing produces more than Airbus and earns higher profits in state one because Boeing’s cost advantage remains intact when French espionage is unsuccessful. We assume that α − θ − σ is strictly positive so that Airbus produces The assumption that Airbus and Boeing play their duopoly game with full and symmetric information is less restrictive than it appears. Suppose that Boeing was unable to directly detect the loss of its secret. If spying had been successful, Airbus would have an incentive to demonstrate (perhaps discreetly) that it had acquired technology. As a result of such a demonstration, Boeing would reduce its output to the new Nash equilibrium level and Airbus would reap the full benefit of espionage. Of course, Boeing would know that Airbus had not acquired the technology if there was no such demonstration. 1

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even if French spying is unsuccessful. Meanwhile, in state two where espionage is successful, the outputs and profits are symmetric because the cost structures are symmetric. A move from state one to state two, would: [i] increase Airbus’ Nashequilibrium output by 2σ/3β and its profits by 4σ(α - θ)/9β, [ii] reduce Boeing’s Nash-equilibrium output by σ/3β and its profits by 2σ(α - θ + (3/2)σ)/9β, and [iii] increase industry output by σ/3β and consumer surplus by 2σ(α - θ + (3/4)σ)/9β. Table 1. State-Contingent Cournot-Nash Duopoly Outcomes in the Basic Model and the Espionage Versus Counter-Espionage Model

Description Airbus’ Marginal Cost Boeing’s Marginal Cost Airbus’ Output Boeing’s Output Airbus’ Profit Boeing’s Profit Consumer Surplus

STATE 1

STATE 2

Airbus does not receive the secret technology

Airbus receives the secret technology

θ θ-σ (α - θ - σ)/3β (α - θ + 2σ)/3β (α - θ - σ)2/9β (α - θ + 2σ)2/9β 2(α - θ + 0.5σ)2/9β

θ-σ θ-σ (α - θ + σ)/3β (α - θ + σ)/3β (α - θ + σ)2/9β (α - θ + σ)2/9β 2(α - θ + σ)2/9β

B. Optimum Economic Espionage It will be assumed that countries as well as firms are risk neutral. France’s expected “welfare” or net benefit from the aircraft industry is equal to the probability weighted sum of Airbus’ state-contingent profits, minus the cost of espionage by the government. Complications, such as diplomatic embarrassment over unsuccessful intelligence activities, are left aside for simplicity. Meanwhile the expected welfare of the US is synonymous with Boeing’s expected profits, and the expected welfare of consuming countries is simply the expected consumer surplus.

(α-θ-σ) 2 (α -θ +σ ) 2 + x - f(x) 9β 9β

(2)

(α -θ +2σ ) 2 (α -θ+σ) 2 +x 9β 9β

(3)

EWFR (x) = (1 - )x

EWUS (x) = (1 - x)

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EWCC (x) = (1 - x)

2(α -θ+ 12 σ) 2 2(α -θ +σ )2 +x 9β 9β

(4)

Here, f(x) is France’s cost of espionage function. ASSUMPTION 2.0: At all possible penetration rates, 1 ≥ x ≥ 0, the cost of espionage function, f(x), is continuous and twice differentiable such that f' ≥ 0 and f" > 0. Further, f(0) ≥ 0. Since Assumption 2 stipulates that the marginal cost of spying always increases as the probability of penetration is increased, the average variable cost of spying, [f(x) f(0)]/x, is always increasing in the probability of penetration.2 A positive level of spying will often be in France’s national interest. We differentiate equation (2) to determine France’s optimum penetration rate.

∂EWFR = 0 ⇔ ∂x

4σ(α -θ) = f(x) ' 9β

(5)

France’s expected welfare is maximized when the marginal benefit from increasing the penetration rate is equal to the marginal cost. Further, the “marginal benefit of espionage” is equal to the difference between the Nash equilibrium profits in state two and state one which is positive. Given Assumptions 1.0 and 2.0, the optimum penetration rate, ~ x , will be strictly positive if and only if the marginal cost of espionage is less than the marginal benefit when the penetration rate is equal to zero (i.e., f'(0) < 4σ(α - θ)/9β). This result follows from first-order condition (5) because the restrictions on the cost of espionage function given in Assumption 2 are sufficient to guarantee a global maximum. If we relax assumption 2.0 and allow the average variable cost of spying to decline over a sub-domain of low penetration rates, other situations in which spying does not pay can arise. For example, if there were sufficiently large but escapable entry costs associated with spying (i.e., a large enough discontinuity in f(x) at x = 0), the no spying situation would be the global maximum. Similarly, if the marginal cost of spying initially declines (i.e., f" < 0), it could be in a country’s best interest not to spy. In spite of these complications, it is fair to conclude that spying will often pay. The presence or absence of true fixed costs associated with spying (i.e., f(0) > 0) has no effect on the analysis since such costs are inescapable. Further, it may be that a 100% acquisition rate could be obtained with a sufficiently large investment (i.e., f(1) may be finite). For example, France could conceivably purchase Boeing and get its secrets for sure. For simplicity, internal solutions will be assumed throughout most of the discussion. 2

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French espionage is beneficial to the consuming countries as well as France, but it is harmful to the US. Differentiation of equation (3) would indicate that US welfare declines monotonically as the penetration rate rises because Boeing’s profits are higher in state one where spying is unsuccessful. Conversely, differentiation of equation (4) would indicate welfare in consuming countries rises monotonically as the penetration rate rises. France’s optimum penetration rate would increase if Boeing’s technological advantage (i.e., σ) were to increase because the marginal benefit of spying would rise. Further, the extent of French spying is inversely related to the difficulty of espionage because an upward shift in the marginal cost of espionage function would lead to a lower optimum penetration rate. It could be that temporary glut of spying resources in the aftermath of the Cold War has led to increased economic espionage because of unusually low marginal costs. Whereas the presence of domestic consumers would weaken the case for a strategic export subsidy because such a subsidy would raise the domestic price, domestic consumers stand to gain from economic espionage. Suppose that France accounts for ξ percent of the world consumption and, thereby, obtains ξ percent of the world consumer surplus. In this case, the marginal benefit of French spying would increase by ξσ(α - θ + (3/4)σ)/9β and the optimal penetration rate would increase accordingly.3 If Assumption 1.0 holds, and if the optimum penetration rate is positive, then espionage must generate a favourable strategic effect as well as a direct cost saving. We have seen that the difference between Airbus’ Nash equilibrium profits in state two and state one, 4σ(α - θ)/9β, which is a positive constant. The cost saving on Airbus’ zero-spying (state-one) Nash equilibrium output given in Table 1 is only σ(α - θ - σ)/9β. Thus, there is a strategic effect that is equal to σ (α - θ + 3σ)/9β > 0 arising from the shift in expected outputs toward Airbus and away from Boeing. The presence of the strategic effect of moving from state one to state two, in addition to the cost saving, raises the marginal benefit of espionage and beckons forth additional spying. Just as the type of strategic trade policy (i.e., export subsidies versus taxes) depends critically on the type of rivalry among firms (see Eaton and Grossman, 1986), the case for economic espionage is highly sensitive to the type of oligopolistic rivalry. In particular, the fact that the strategic effect is beneficial hinges critically on the assumption of Cournot rivalry between Airbus and Boeing. The strategic effect would be harmful to France if the two firms played a Bertrand game. Consider such a Bertrand case. Given homogeneous products and constant marginal production costs, Boeing would set its price just below Airbus’ marginal cost in the state-one Bertrand game where spying has been unsuccessful. Airbus would earn zero profits by staying 3 When there are US consumers, the adverse effect of French spying on US welfare is smaller. Given linear demand and constant marginal production costs, however, US welfare would fall monotonically as French spying increased even if all consumption took place in the US.

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out of the market. In state two where spying is successful, the Bertrand price would be equal to the common marginal cost. Both Airbus and Boeing would produce with zero profits, and the increase in Airbus’ profits in moving from state one to state two would be equal to zero. Thus, with homogeneous products and constant marginal costs as well as Bertrand rivalry, the adverse strategic effect of spying would entirely offset the beneficial cost saving. In such a situation, economic espionage would always be counter productive. 3. ESPIONAGE VERSUS COUNTER ESPIONAGE We now extend the basic model by allowing the US to take defensive action. In the first stage, France and the US will play an espionage versus counterespionage game where the two countries choose their investments in intelligence s i m u l t a n e o u s l y . 4 The results of intelligence activity are then revealed to the firms. Finally, Airbus and Boeing play a Cournot duopoly game. Since France and the US will anticipate the subsequent actions of the firms when they play the intelligence game, it is necessary, once again, to solve the model backwards. A. State-Contingent Cournot Duopoly Sub-Games The probability that French spies will successfully penetrate Boeing is still x, but now the probability that the US will intercept the French agents (i.e., the “interception rate”) is y. While there are four possible outcomes of espionage, there are only two distinct states. State one where Airbus does not receive the technology arises: [i] if French agents fail to penetrate Boeing and US agents fail to intercept them, [ii] if French agents fail to penetrate Boeing and US agents succeed in intercepting them, or [iii] if French agents succeed in penetrating Boeing and US agents intercept them. Since the probabilities of these respective events are: [i] (1 - x) (1 - y), [ii] (1 - x)y, and [iii] xy, the probability of state one is: 1 - x (1 - y). State two, where airbus receives the technology, arises only if French agents penetrate Boeing and US agents fail to intercept them. Thus, the probability of state two is x(1-y). Meanwhile, the statecontingent values of marginal costs, outputs, profits and consumer surpluses continue to be given by Table 1. B. The Espionage Versus Counter-Espionage Game The French cost of espionage function is f(x) and the US cost of counter-espionage function is g(x). We could allow either the US or France to be a first-mover but this would have little effect on the qualitative results of the model. 4

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Table 1. State-Contingent Cournot-Nash Duopoly Outcomesin the Basic Model and the Espionage Versus Counter-Espionage Model

Description

STATE 1

STATE 2

Airbus does not receive the secret technology

Airbus receives the secret technology

θ θ-σ (α - θ - σ)/3β (α - θ + 2σ)/3β (α - θ - σ)2/9β (α - θ + 2σ)2/9β 2(α - θ + 0.5σ)2/9β

θ-σ θ-σ (α - θ + σ)/3β (α - θ + σ)/3β (α - θ + σ)2/9β (α - θ + σ)2/9β 2(α - θ + σ)2/9β

Airbus' Marginal Cost Boeing's Marginal Cost Airbus' Output Boeing's Output Airbus' Profit Boeing's Profit Consumer Surplus

ASSUMPTION 2.1: For all possible penetration rates, 1 ≥ x ≥ 0, the cost of espionage function, f(x), is continuous and twice differentiable such that f' ≥ 0 and f" > 0, and for alll possible interception rates, 1 ≥ y ≥ 0, the cost of counter-espionage function, g(y), is continuous and twice differentiable such that g' ≥ 0 and g" > 0. Further, f(0) ≥ 0 and g(0) ≥ 0. Expected welfare functions can be developed by using the appropriate probabilities to weight the payoffs for states one and two and then deducting the appropriate costs of intelligence.

EWFR (x , y) = (1 - (x1 - )y)

(α -θ-σ) 2 (α -θ+σ) 2 + x(1 - )y - f( x) 9β 9β

(6)

EWUS (x,y) = (1 - (x1 - )y)

(α -θ +2σ ) 2 (α -θ +σ ) 2 + x(1 - )y - g(y) 9β 9β

(7)

EWCC (x,y) = (1 - (x1 - y))

2(α -θ + 12 σ ) 2 2(α -θ+σ) 2 + x (1 - )y 9β 9β

(8)

French welfare is monotonically decreasing in the US interception rate, and US welfare is monotonically decreasing in the French penetration rate. Further, the welfare of consuming countries rises as French espionage increases, but falls as US counter espionage increases. France maximizes its expected welfare by choosing the probability of penetration

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optimally, and the US maximizes its welfare by choosing the probability of interception optimally. ∂EWFR = 0 ⇔ ∂x

4σ(α -θ) (1 - )y = f (' x) 9β

(9)

∂EWFR = 0 ⇔ ∂y

2σ(α -θ+ 23 σ ) x = g(y) ' 9β

(10)

The first-order conditions for the maximization of expected welfare given by equations (9) and (10) are reaction functions in implicit form for France and the US. In Figure 1, the reaction functions of France and the US are RFFR and RFUS. In the case where the cost of intelligence functions are quadratic, the reaction functions are linear. Given Assumption 2.1: [i] both reaction functions are continuous, [ii] the French reaction function is negatively sloped, and [iii] the US reaction function is positively sloped. Consider the French reaction function. If the probability of interception is equal to zero, condition (9) for optimal French spying is equivalent to condition (5) in the simple model of the previous section. An increase in the US interception rate will lead to a decrease in the optimal French penetration rate along the French reaction function. Since an increase in the interception rate leads to a decrease in the marginal benefit of espionage, France “reacts” by reducing its penetration rate. Now, consider the US reaction function. As the French penetration rate increases, the marginal benefit of counter espionage increases and the US responds by increasing the interception rate. In Figure 1, the bliss point for France is at BP (where x = ~x and y = 0) because France’s welfare falls as the US probability FR

of intercepting its agents increases. The bliss point for the US is at ZI (where there is zero intelligence activity) because US welfare falls as the French probability of penetration of Boeing rises. In Figure 1, the Nash equilibrium is at NE where the penetration rate is x* and the interception rate is y*. The Nash equilibrium isoexpected-welfare contours or “indifference curves” of France and the US are EW*FR and EW*US. If it would be optimal for France to spy in the absence counter espionage, the introduction of optimal counter espionage by the US will typically lead to a reduction in French spying but it will not eliminate French spying. PROPOSITION 1: Given Assumptions 1.0 and 2.1, the Nash equilibrium penetration rate, x*, must be strictly positive if and only if f'(0) < 4σ(α - θ)/9β. In other words, the optimum expenditure on espionage is positive unless the marginal cost of spying is at least as large as the marginal benefit when both the penetration and

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interception rates are equal to zero. If f'(0) < 4σ(α - θ)/9β and y = 0, then espionage will occur just as it did in the basic model. Thus, it remains to prove that espionage will be positive if f'(0) < 4σ(α - θ)/9β and the Nash equilibrium interception rate is positive. Suppose that –y is the level of US counter espionage that is just sufficient to drive French spying to zero. Of course, it must be the case that 1 ≥ –y > 0. It is now possible to show that an intelligence combination consisting of x = 0 and y ≥ –y cannot be a Nash equilibrium. This is because the marginal benefit of counter espionage is equal to zero when x = 0 according to equation (10) while the marginal cost of espionage at –y > 0 is strictly positive according to Assumption 2.1. Thus, the Nash equilibrium must be such that ~x ≥ x* > 0 and –y > y* ≥ 0. For the range of parameters where any counter espionage pays, optimal counter espionage will reduce but not eliminate spying.

Even when US counter espionage is possible, spying remains beneficial to the consuming countries and France, but harmful to the US.

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PROPOSITION 2: If Assumptions 1.0 and 2.1 hold, and if x* > 0 and y* ≥ 0 are the Nash equilibrium penetration and interception rates, then it must be the case that: [i] E WCC(x*, y *) > E WCC (0, 0), [i i] E W FR(x*, y *) > E W FR(0, 0), and EW US(x*, y *) < EWUS(0, 0). Since the US Nash equilibrium indifference curve cannot cross the US reaction function in Figure 1, the US must be worse off at the Nash equilibrium, NE, than at the zero intelligence position, ZI (i.e., EWUS(x*, y *) < EWUS(0, 0)). According to equation (8), the expected welfare of the consuming countries depends positively on x(1 - y) which is the probability of state 2 where France successfully acquires the cost saving technology for Airbus. Since this probability is higher when spying is present than when it is absent (i.e., with x > 0) regardless of the Nash-equilibrium level of counter espionage, y* (where 1 ≥ –y > y* ≥ 0), the consuming countries are better off in the Nash equilibrium (i.e., EWCC(x*, y*) > EWCC(0, 0). France is also better off at the Nash equilibrium. At all points along the vertical axis, France’s expected welfare is constant. Thus, the French indifference curve through point ZI is vertical. Since indifference curves cannot intersect, France’s expected welfare at NE must be greater than at ZI (i.e., EWFR(x*, y*) > EWFR(0, 0)). Figure 1 indicates that both producing countries would be better off if they could move into the lens created by the Nash equilibrium indifference curves. Further, any position in the core of the intelligence game involves some espionage, but no counter espionage. All positions in the core of the game must be: (i) efficient in the sense that neither player can be made better off without making the other worse off, and (ii) mutually beneficial in the sense that each player is at least as well off as in the (noncooperative) Nash equilibrium. PROPOSITION 3: If Assumptions 1.0, and 2.1 hold and if x* > 0 and y* ≥ 0 are the Nash equilibrium penetration and interception rates, then for any cooperative solution, (x^, ^y), that lies in the core it must be that: [i] 0 < x^ < x*, and [ii] y^ = 0 ≤ y*. First we will establish that there is no counter espionage in the core (i.e., ^y = 0 ≤ y*). In Figure 1 the efficiency locus or contract curve, CC, must lie between the two bliss points along x axis where there is no counter espionage (i.e., y = 0). If a combination of probabilities was efficient and if both x and y were strictly positive, then the indifference curves of France and the US would have to be tangent. Such tangencies, however, cannot arise. Since the joint probability of technology transfer to Airbus is x(1 - y), lines of constant probability have a positive slope equal to (1 y)/x in (x,y) probability space. Moving up and to the right along any such constant probability line leaves both countries worse off because their intelligence costs rise but their expected benefits remain the same. Thus, (positively-sloped) tangencies between the indifference curves of France and the US cannot arise, and y must be equal to zero at all points on the contract curve. The efficient interception rate is

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always equal to zero because counter espionage is purely defensive. Since any position in the core must be efficient, all such points entail zero counter espionage. Next, it is necessary to show that the level of spying activity in the core must be positive but less than in the Nash equilibrium (i.e., 0 < x^ < x *). Given that all positions in the core of the game involve no counter-espionage activity, no such position can involve more espionage than in the Nash equilibrium or the US would be worse off. Further, recall that Proposition 2 established that France’s expected welfare at NE must be greater than at ZI in Figure 1. Since all positions in the core must be no worse than the Nash equilibrium for France, all such solutions require positive espionage as well as zero counter espionage. While the clandestine nature of intelligence would make it virtually impossible for France and the US to credibly commit to positive but lower levels of espionage and no counter espionage, the two countries would be better off if they could do so. 4. TWO-WAY AGGRESSIVE ESPIONAGE We now open the opportunity for aggressive espionage to be performed by both the United States and France, but assume that neither country conducts counter espionage. In this model, both firms must have technology or information that is valuable to the other. ASSUMPTION 1.1: Each firm possesses a single, discrete and indivisible marginal cost-saving technology. The cost-saving technologies of the two firms are fully compatible but the cost reductions are not necessarily of the same magnitude. Let θ denote the marginal cost of production with the previous generation technology, and let σA and σB denote the reductions in marginal cost associated with the new secret technologies of Airbus and Boeing respectively. In the absence of spying the marginal production costs of Airbus and Boeing would be θ - σA and θ - σB. Since the two secret technologies are completely compatible, the marginal cost would be θ - σA - σB if the two technologies were utilized together. A. State-Contingent Cournot Duopoly Sub-Games The probability that French spies will successfully penetrate Boeing and acquire its technology is x and the probability that the US spies will successfully penetrate Airbus is z. The joint probabilities, marginal costs, profits and consumer surplus associated with each of the four possible states are shown in Table 2. In state one where neither firm has obtained the other’s secret, Airbus earns greater profits than Boeing if and only if its secret technology is superior to that of Boeing (i.e., iff σA > σB). In state two, where only French spying has been successful, Airbus has a cost advantage over Boeing that gives rise to higher Nash equilibrium profits. State three

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is the reverse of state two; Boeing has a cost advantage that gives rise to higher profits than Airbus because US spying has been successful while French spying has been unsuccessful. In state four, the costs of Airbus and Boeing are the same because both French and US spying efforts have been successful and, consequently, the profits of the two firms are identical. The Nash-equilibrium profit of Airbus (Boeing) is highest in state two (three) and lowest in state three (two), while the Nash-equilibrium consumer surplus is highest in state four and lowest in state one. B. The Two-Way Spying Game The cost of espionage functions of France and the US are f(x) and h(z) respectively. Assumption 2.2: For all penetration rates 1 ≥ x ≥ 0 and 1 ≥ z ≥ 0, the cost of espionage functions, f(x) and h(z), are continuous and twice differentiable such that f' ≥ 0, f" > 0, h' ≥ 0 and h" > 0. Further, f(0) ≥ 0 and h(0) ≥ 0. Notice that the cost functions of the two countries need not be identical. Expected welfare functions can be developed for France, the US and the consuming countries by combining the joint probabilities from Table 2 with the appropriate statecontingent Nash equilibrium payoffs.

(α -θ +2σ A -σ B ) 2 (α -θ+ 2σ A +σ B ) 2 EWFR (x , y) = (1 - )x(1 - )z + x(1 - )z 9β 9β (α -θ +σ A -σ B ) 2 (α -θ +σ A +σ B ) 2 + 1( - )xz + xz - f( x) 9β 9β

(11)

(α -θ+ 2σ B −σ A ) 2 (α -θ +σ B +σ A ) 2 EWUS (x,y) = (1 - )x(1 - )z + x(1 - )z 9β 9β (12) (α -θ +2σ B +σ A ) 2 (α -θ +σ A +σ B ) 2 + (1 - )xz + xz - h( z) 9β 9β

[

]

2 α-θ+ 21 (σ A +σ B ) EWCC (x,y) = (1 - )x(1 - )z 9β + (1 - )xz

2(α -θ +σ A + 12 σ B ) 2 9β

2

2(α -θ + 12 σ A +σ B ) 2 9β (13) 2(α -θ +σ A +σ B ) 2 + xz 9β + x (1 - )z

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France’s expected welfare declines as the US penetration rate increases, and US expected welfare falls as the French penetration rate increases. Meanwhile, the expected welfare of the consuming countries is positively related to both penetration rates. Each country maximizes its expected welfare by optimally choosing its probability of penetrating the foreign firm through espionage.

∂EWFR 4σ B = 0 ⇔ ' [α -θ +(2 - z)σ A ] = f(x) ∂x 9β

(14)

∂EWUS 4σ A =0 ⇔ ' [α -θ+(2 - x)σ B ] = h(z) ∂z 9β

(15)

It should be observed that if Airbus did not have a secret to steal (i.e., if σA = 0), then equation (14) would be equivalent to equation (5) in the basic model. Of course, in such a case the equation (15) dictates that the US would not spy. The first-order conditions for the maximization of expected welfare given by equations (14) and (15) constitute reaction functions in implicit form for France and the US. In Figure 2, the reaction functions of France and the US are RFFR and RFUS. These reaction functions will be linear if the cost of espionage functions are quadratic. Given assumption 2.2, both reaction functions must be continuous and negatively sloped, and the probabilities of penetration will be strategic substitutes in the sense of Bulow et. al. (1985). For example, an increase in US spying will lead to a decrease in the optimum level of French spying along the French reaction function. Since an increase in the US probability of penetration leads to a decrease in the marginal benefit of French espionage, France “reacts” by reducing its probability of penetration. In Figure 2, the Nash equilibrium is at NE where penetration rates of France and the US are x* and z*. It will typically be the case that least one of the producing countries conducts spying operations in the Nash equilibrium. PROPOSITION 4: Given Assumptions 1.1 and 2.2, at least one the Nash equilibrium penetration rates, x * and y *, will be strictly positive if and only if f'(0) < 4σB (α - θ + 2σA)/9β and h'(0) < 4σA (α - θ + 2σB)/9β. If the marginal cost of French espionage is strictly less than the marginal benefit when both penetration rates are equal to zero (i.e., f'(0) < 4σB (α - θ + 2σA)/9β), it would be optimal for France to spy if the US did not. By the same token, if the marginal cost of US spying is strictly less than the marginal benefit when the both penetration rates are

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equal to zero (i.e., h'(0) < 4σA (α - θ + 2σB)/9β), it would be optimal for US to spy if the France did not. Thus, if both conditions hold, at least one of the two countries will spy in the Nash equilibrium.

When France and the US engage in retaliatory spying there is over-investment in espionage. PROPOSITION 5: Suppose that Assumptions 1.1 and 2.2 hold. If x* > 0 and z* > 0 are the non-cooperative Nash equilibrium penetration rates for the two-way espionage game, then for any cooperative solution, (x^, ^z), that lies in the core it must be that: [i] x^ < x*, and [ii] ^z < z*. In Figure 2, the contract curve or efficiency locus, CC, must pass through the lens created by the Nash equilibrium indifference curves, EW*FR and EW*US. Clearly, both countries could be made better off with lower levels of investment in espionage (e.g., at point LI). There is little chance, however, that countries could credibly commit themselves to lower levels of spying because espionage is inherently secretive and any

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treaty would be prohibitively costly to monitor. Interestingly enough, it is possible that all countries could gain from spying. PROPOSITION 6: Suppose that Assumptions 1.1 and 2.2 hold. If at least one of the Nash equilibrium penetration rates, x* and z *, is strictly positive in the two-way spying game, then it must be the case that EWCC(x*, z *) > EWCC(0, 0), and it may be the case that: EWFR(x*, z*) > EWFR(0, 0) and/or EWUS(x*, z*) > EWUS(0, 0). Since the welfare of the consuming countries given by equation (13) increases monotonically as either producing country’s penetration rate rises, it follows immediately that such countries must be better off in the presence of spying. Welfare may be higher for either or both producing countries. For example, consider the extreme case where the Nash equilibrium penetration rates are x* = 1 and z* = 1 and the secrets are symmetric (i.e., σA = σB). In such a Nash equilibrium, state four would arise with certainty. Table 2 indicates that with symmetric secrets both firms earn higher profits in state four than in state one (which would arise with certainty if there were no espionage). Thus, if the equilibrium costs of espionage, f(1) and h(1), are sufficiently small, both countries will be better off. Figure 2 shows a less extreme case where both countries are better off. Both France and the U S have higher expected welfare in equilibrium at the NE than in the zero intelligence position at ZI. Such mutual gains are more likely when the secrets are significant and investments in espionage are reasonably certain to transfer information.5 The possibility that welfare is higher for either or both countries with spying than without arises because espionage is essentially a means of transferring technology from one firm to another. Espionage, however, is an inefficient means of technology transfer because it unnecessarily absorbs resources and because the transfer of information is unnecessarily uncertain. Thus, the model suggests that even if a treaty to reduce spying to efficient levels is not a plausible option, it may be possible for both nations to experience welfare improvements by engaging in more efficient, cooperative forms of technology transfer such as joint ventures in research and development. 5. CONCLUSION Economic espionage is an area where public policy opinions are divided. Those in favour can argue that the purpose of a national intelligence agency is to 5 An anonymous referee has pointed out that when Cournot firms can undertake marginal-cost reducing activities such as capital investments, they typically over invest. Consider a more complicated model where Airbus and Boeing make such investments. If capital investment and espionage are complementary, then it would be less likely that both countries would gain from espionage because spying would attenuate the over-investment problem.

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safeguard the national interest. The economic performance of domestic firms in key oligopolistic industries can certainly be classified as an activity that affects a country’s security and welfare. Engaging the spy service to advance the interests of firms, particularly when the state is closely aligned to or has ownership interests in the firm, may well be a sensible way to employ the existing intelligence infrastructure. Those opposed to espionage can argue that it is a “band-aid” solution to greater problems of technological competitiveness. Further, the secretive nature of spying makes it difficult to determine whether national spy agencies act in the national interest or their own interest. The threat of economic espionage may be exaggerated by national intelligence agencies in order to protect their budgets. Such rent-seeking activity could result in additional costs for industry as well as government. Security measures undertaken at the firm level, on the advice of the national intelligence agency, could cause an increase in fixed and/or variable costs that would serve to reduce the competitiveness of domestic firms in international markets. The wisdom of economic espionage is also open to question on the grounds that there may be more effective means of technology transfer that eliminate the resource costs and uncertainties associated with spying. This paper has explored the economic rationale for economic espionage in order to shed light on this debate. Many details of a firm’s operations and corporate practices are legally observable by conducting market research, inspecting patent applications, gathering marketing literature and following academic journals. However, in oligopolistic industries where there are potential direct and strategic benefits from the development of new processes, secrecy has a role in protecting current and future profits. While economic espionage is a costly activity, it has the potential to yield desirable strategic or profit-shifting effects as well as cost savings for domestic firms. Consequently, economic espionage can be in the national interest. Since producers in the target country are hurt by the strategic effects of economic espionage, target-country responses can be anticipated. Although a target country can reduce the potential damage by conducting counter espionage, the aggressive country will typically still gain from spying. When both producing countries spy aggressively, either or both may be better off because of the technology transfer which is implicit in espionage. A related paper (Gaisford and Whitney, 1998) shows that economic espionage unambiguously reduces the incentive to conduct research and development for the firm in the target country but, once again, the spying country will typically gain. The argument for economic espionage is unlike the argument for export subsidies but similar to the argument for production subsidies in that it is strengthened by the presence of domestic consumers. Spying itself is generally beneficial to consumers because typically the expected world output rises, the expected price falls and the expected consumer surplus is enlarged. There are at least two important caveats to the argument that economic espionage can enhance national welfare. First, some of the profits that are shifted to “domestic”

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firms via espionage will actually accrue in foreign countries because of the global ownership of many of the large firms that dominate imperfectly competitive world markets. Clearly, this dissipation of additional profits may arise with international consortiums such as Airbus as well as publicly traded corporations. A second qualification arises in the case where there is a Bertrand rather than Counot oligopoly. Domestic firms would still benefit from lower marginal costs whenever spying was successful, but the strategic effect of lower prices would be adverse for all the producers. Whether economic espionage is a virtue or a vice, it is likely to remain a reality. Even if economic espionage were sufficiently transparent to make a no-spying treaty possible, there would be a time inconsistency problem with such a treaty. Initially, a no-spying treaty might be advantageous to all parties in order to stimulate R&D activity, but once the R&D costs were sunk, each producing country would have an incentive to renege. REFERENCES Brander, James A., “The Economics of Economic Intelligence,” in Evan Potter, ed., Intelligence and National Security, Ottawa: Carleton University Press, 1997. Brander, James A., and Spencer, Barbara J., “Export Subsidies and International Market Share Rivalry,” Journal of International Economics, February, 1985, 83100. Branson, William H. and Klevorick, Alvin K., “Strategic Behaviour and Trade Policy,” in Paul Krugman, ed., Strategic Trade Policy and the New International Economics, Cambridge, MA: MIT Press, 1986. Bulow, J. I., Geanakoplos, J. D., and Klemperer, P. D., “Multimarket Oligopoly: Strategic Substitutes and Complements,” Journal of Political Economy, June 1985, 488-511. Dixit, Avinash, “International Trade Policy for Oligopolistic Industries,” Economic Journal, 1984 Supplement, 1-16. Dixit, Avinash K., and Kyle, Albert S., “The Use of Protection and Subsidies for Entry Promotion and Deterrence,” American Economics Review, March 1985, 139-152. Eaton, Jonathan, and Grossman, Gene M., “Optimal Trade and Industrial Policy Under Oligopoly,” Quarterly Journal of Economics, May 1986, 383-406. Gaisford, James D, and Merrill E. Whitney (1998). “Economic Espionage and the Incentive to Innovate,” Mimeo. Gal-Or, Esther, “Information Sharing in Oligopoly,” Econometrica, March 1985, 329343. Grossman, Gene M., “Strategic Export Promotion: A Critique,” in Paul Krugman, ed., Strategic Trade Policy and the New International Economics, Cambridge, MA: MIT Press, 1986. Porteous, Samuel, “Economic Espionage,” Commentary, Canadian Security

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Intelligence Service (No. 32) May 1993. Security Management “Votre Secrets, Monsieur ?” October 1992. Time Magazine “Snooping Among Friends,” June 7, 1993, 40-41. Turner, Stansfield, “Intelligence for a New World Order,” Foreign Affairs, Fall 1991, 150-66. Vives, Xavier, “Duopoly Information Equilibrium,” Journal of Economic Theory, October 1984, 71-94.

Mailling Address: Dr. Merrill E. Whitney, Department of Economics, University of Calgary, Calgary, Alberta, Canada T2N 1N4. Tel: 403-220-3157, Fax: 403-2825262. Mailling Address: Professor James D. Gaisford, Department of Economics, University of Calgary, Calgary, Alberta, Canada T2N 1N4. Tel: 403-220-3157, Fax: 403-282-5262, e-mail: gaisford@ucalgary.ca.

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