How Small Open Economies Can Leverage the Trade in Ideas

New thinking on innovation, trade and productivity

Published: May 2, 2017

Author: Dan Ciuriak

Key Points

  • The concept of “freedom to operate” (FTO) — a term of art in intellectual property (IP) management practice — inspires a generalization to capture the freedom established by modern deep and comprehensive economic partnership agreements for multinational firms to operate internationally in their preferred modes, whether cross-border trade, establishment of foreign affiliates, entering into joint ventures or licensing production of their proprietary goods and services.
  • Generalized freedom to operate (GFTO) reduces costs for multinational firms by facilitating substitution across modes of operation, given an uneven international operating environment. This source of gain has generally been overlooked in evaluations of modern economic partnership agreements.
  • GFTO is likely to have asymmetric effects across economies and across the population of firms, favouring larger markets and larger firms.
  • The policy implication is that small, open economies need to pay careful attention to the design of agreements, not to impede optimization across modes, but rather to ensure their own firms fully benefit from it by countering the anti-competitive effects of power asymmetry, including:
    • strengthening the competition policy framework to counter competition-reducing mergers and acquisitions (M&A) activity, especially when it works to reduce the dynamism of local innovation networks;
    • redressing the imbalance in lobbying power through a major overhaul of the consultation framework in which trade agreements are negotiated; and
    • facilitating access to preferential windows for small and medium-sized enterprises (SMEs).

s Canada prepares to negotiate, or renegotiate, trade arrangements in a new post-Trans-Pacific Partnership (TPP), possibly post-North American Free Trade Agreement and — if it dare be imagined — post-World Trade Organization world, it becomes vital to understand what it was about the established model of globalization, and the trade agreements that helped to generate it, worked for small, open economies such as Canada. Equally important is to understand what worked against their interests and, more generally, what it was about this model that sowed the seeds for the potentially paradigm-wrenching changes now asserting themselves on the global stage.

While apprehension about what devil comes next runs high, it must be acknowledged that the established model — the devil we know — was flawed. This is evidenced by numerous economic indicators literally going off the charts — ranging from zero-bound-breaking nominal interest rates, to a socially destructive widening of income disparities, to soaring and destabilizing financialization — and by the persistence of a general economic malaise, reflected in disappointing performance on business dynamism, labour markets and innovation.

This essay examines one feature of the existing model, namely the imbalance in the conditions of competition it establishes between labour and capital and between established and upstart capital. Whereas labour’s ability to compete on the global market is sharply curtailed by immigration laws — and stands to be even more constrained in future — capital is free to flow across borders with virtually no restrictions and receives extraordinary protection in its destination economies. This regime was established by an accretion of laws over decades, but were being perfected in modern deep and comprehensive economic partnership agreements, such as the TPP, which provide multinational firms with an unparalleled degree of freedom to operate internationally, in whatever mode of international commerce they choose. 

A new concept — GFTO — is useful in developing this argument. The following sections develop this concept, describe how modern deep and comprehensive economic partnership agreements create the GFTO, and discuss the impacts of this regime on the dynamism of the global economy and the relative interests of small, open economies.

Generalizing the Concept of FTO

FTO refers to the ability of a company to develop, produce and market products without legal liabilities for infringement on intellectual property rights (IPRs) held by third parties. Establishing FTO is an integral part of the process of innovation in today’s IPR-rich environment. Prior to committing funds to develop a product, a firm must identify valid third-party IPRs, any infringement-related risk that proceeding with the development of the product entails and strategies to manage the risk. In current practice, firms establish FTO through an opinion based on patent search (an activity for which an industry has been called into existence, because of patent proliferation); through a cross-licensing agreement between parties holding patent portfolios that might trigger infringement, depending on the precise nature of a prospective commercial undertaking; by acquiring patent rights; or through a similar but less costly stratagem of defensive publishing (which, in theory, prevents others from acquiring patents).

Freedom to operate refers to the ability of a company to develop, produce and market products without legal liabilities for infringement on IPRs held by third parties.

The risk of being sued for infringement of IP is, however, only one of many risks faced by firms whose value depends on their intangible assets when they introduce products into domestic and international markets. For the modern multinational enterprise, the ability to protect intangible assets and to recoup investments when entering foreign markets influences decisions as to how to operate in various countries.

In their production decisions, firms choose whether to conduct specific activities in-house, to outsource domestically or offshore at arm’s length, to invest abroad and obtain inputs through intra-firm trade, to license production of inputs to firms abroad, or to enter into joint ventures. In marketing their products, they face a similar range of options. The various decisions combine to define the boundaries of any given firm; this insight invokes a massive literature, starting with the work of Ronald Coase (1937). 

Importantly, the choices made by firms depend not only on technical considerations concerning the nature of the production and marketing processes, but also on considerations concerning the institutional environment in which the products are developed, produced and marketed. 

Technical considerations include, for example, economies of scale in production (which point to concentrating production activities in one location), location of key inputs (either raw materials or technically skilled personnel), production costs (including transportation and border costs of offshore activities that form part of the firm’s value chain), the role of tacit information (information that cannot be codified for purposes of outsourcing) and issues of process management (just-in-time delivery, coordination of activities and so on). The extensive literature on governance of global value chains (GVCs) explores these issues in depth (see, for example, Sturgeon [2007], for an accessible summary).

Institutional considerations include the ability to write, and enforce, contracts that capture quasi-rents; risks of knowledge spillovers in destination countries that reduce profits; and risks of expropriation. Institutional quality in the general sense of protecting property rights has been strongly linked to long-run economic growth (for example, Acemoglu and Robinson [2012]). Given the importance of trade in economic development, one of the causal links runs through trade: countries with better institutions tend to trade more (Dollar and Kraay 2003). Similarly, better institutions unlock foreign direct investment (FDI) (Alfaro, Kalemli-Ozcan and Volosovych 2005). Investing firms obtain access to new profit streams from new markets; destination countries benefit from the inflow of capital and positive spillovers from the presence of multinational firms on suppliers and customers, although they face risk of FDI crowding out domestic suppliers and minimizing horizontal spillovers to potential domestic competitors. Finally, international transactions are facilitated by the ability to write and enforce contracts that capture quasi-rents (Antràs 2003; Antràs and Helpman 2004; Antràs and Helpman 2008), the ability to prevent knowledge spillovers in destination countries that reduce profits (Blomström and Kokko 2003) and some assurance against de jure or de facto expropriation by foreign governments (Azzimonti and Sarte 2007).

Accordingly, weaknesses in the international institutional context restrict firms’ freedom to operate globally, in much the same way that third-party IPRs restrict firms’ freedom to operate in product development (in the narrow traditional sense of this term). Similarly, changes to the institutional context that remove institutional constraints expand firms’ freedom to organize their international engagement on an optimal basis.

Given the importance of trade in economic development, one of the causal links runs through trade: countries with better institutions tend to trade more.

The concept of FTO thus generalizes readily to cover the features of an institutional setting that present risk to a firm’s value, ranging from leakage of trade secrets, IPR infringement and de facto expropriation of a profitable line of business, to regulatory change or competition from a state-owned enterprise.1

Viewed through this lens, modern deep and comprehensive economic partnership agreements such as the TPP can be conceptualized not only as reducing transactional costs of international business but also as expanding the GFTO, through their disciplines on intellectual property, investment (including freedom of capital flows and investor-state dispute settlement), state enterprise (for example, through imposing on governments the principle of competitive neutrality when engaging in commercial activity) and government procurement, and by generally providing a legal framework for drafting enforceable contracts.

In terms of the national interest, the asymmetry would seem to favour the major economies, which disproportionately house the seats of the multinationals. To be sure, it is important for smaller economies that their homegrown firms enjoy an environment that equally enables international expansion.

It is ultimately an empirical question as to whether the system has overshot on the side of protecting established firms and thus reduced competition (including from new and potentially disruptive start-ups), increased concentration, weakened the bargaining position of labour and, generally, made the economy more sclerotic — including through feedbacks such as large established companies with large government relations budgets being able to more effectively lobby for policies and rulings that favour their established business models.

Economic Implications

The concept of GFTO has a number of implications for firms engaged in international commerce.

First, an expanded GFTO implies additional cost reductions, because it frees firms to choose the most cost-effective means of organizing their international engagement, whether by extracting value from their knowledge assets in the form of cross-patenting in the destination country, licensing of technology to firms in the destination country, joint ventures, FDI or exports of high technology goods that could be reverse-engineered. If there is imperfect substitutability across modes of international engagement, which is almost certainly the case, an improvement in the institutional setting to facilitate mode switching would expand firms’ profits and thus the rate of return on their capital. 

Second, the improved returns to capital imply a revaluation of the tangible and intangible assets of firms operating internationally as traders, participants in GVCs or foreign investors, including the value of their capital based on profit expectations, a consideration pertinent to the inclusion of investor-state dispute settlement mechanisms in trade and investment agreements. An expanded market cap, in turn, represents competitive advantage for firms involved in M&A activity. This clearly plays to the advantage of the large established multinationals, given the asymmetry in M&A activity, where the big swallow the small.

Trade agreements that focus on perfecting GFTO for multinationals while paying little attention to supporting SME competitors, tend to exacerbate imbalances in the economic system. (Photo: Efired /

Policy Implications

GFTO explains how the chapters of trade and investment agreements that cover intellectual property, competition policy, investment and government procurement combine to create commercial flexibility to choose optimal forms of international operation, in the broader sense implied by Jim Balsillie (2016). 

Since multinationals are best able to exploit alternative modes of operation, GFTO works most powerfully for them in enabling optimization of the deployment of their tangible and intangible assets. Given that multinationals start out as the dominant firms in any economic system, trade agreements that focus disproportionately on perfecting GFTO for them — while paying little more than lip service to measures to strengthen the hand of upstart SMEs — will tend to exacerbate imbalances in the economic system. In the context of “second-best” outcomes, the improvement of efficiency that GFTO promises may, therefore, come at the cost of systemic problems.

The main policy implication for the design of future agreements is not necessarily to re-introduce costs that impede optimization across modes but rather to:

  • strengthen the competition policy framework to counter competition-reducing M&A activity, especially when it works to reduce the dynamism of local innovation networks;
  • redress the imbalance in lobbying power through a major overhaul of the consultation framework in which trade agreements are negotiated; and
  • facilitate access to preferential windows for SMEs by liberalizing the de minimis provisions for rules-of-origin documentation, to enable a greater utilization of agreements by these firms.

For small, open economies, the additional policy implication is the need for innovation framework policies aimed at ensuring that strengthened GFTO for multinationals does not effectively impair GFTO for their own start-ups.

1 This more general sense of the term “freedom to operate” is implied in evidence given by Jim Balsillie before the Standing Senate Committee on Foreign Affairs and International Trade ( and the House of Commons’ Standing Committee on International Trade (Balsillie 2016), in which he mentions a broad range of capacities that governments need to develop to protect the FTO of firms in their jurisdiction. These actions include: prior art libraries (public, private), patent pools (private, sovereign public), bilateral and multilateral negotiating sophistication, judicial strategies (provincial, federal, global), sophisticated standards insertion and strategic regulations strategies, collaboration frameworks (public/private, private/private) and education.


Works Cited

Acemoglu, Daron and James Robinson. 2012. Why Nations Fail: The Origins of Power, Prosperity, and Poverty. New York, NY: Crown Publishing.

Alfaro, Laura, Sebnem Kalemli-Ozcan and Vadym Volosovych. 2005. “Why Doesn’t Capital Flow from Rich to Poor Countries? An Empirical Investigation.” Working Paper 11901. National Bureau of Economic Research, December.

Antràs, Pol. 2003. “Firms, Contracts, and Trade Structure.” Quarterly Journal of Economics 118 (4): 1375–1418.

Antràs, Pol and Elhanan Helpman. 2004. “Global Sourcing.” Journal of Political Economy 112 (3): 552–80.

———. 2008. “Contractual Frictions and Global Sourcing.” In The Organization of Firms in a Global Economy, edited by Elhanan Helpman, Dalia Marin and Thierry Verdier, 9–54. Cambridge, MA: Harvard University Press.

Azzimonti, Marina and Pierre-Daniel G. Sarte. 2007. “Barriers to Foreign Direct Investment Under Political Instability.” Federal Reserve Bank of Richmond Economic Quarterly 93 (3): 287–315.

Balsillie, Jim. 2016. Comments to the Standing Committee on International Trade. Trans-Pacific Partnership Agreement (TPP) Public Consultation. 1 sess., 42nd Parliament. Meeting 15, May 5. Evidence/Minutes, 1–2.

Blomström, Magnus and Ari Kokko. 2003. “The Economics of Foreign Direct Investment Incentives.” In Foreign Direct Investment in the Real and Financial Sector of Industrial Countries, edited by Heinz Herrmann and Robert E. Lipsey, 37–56. Berlin, Germany: Springer Verlag.

Coase, Ronald H. 1937. “The nature of the firm.” Economica 4 (16): 386–405.

Dollar, David and Aart Kraay. 2003. “Institutions, trade, and growth.” Journal of Monetary Economics 50 (1): 133–62.

Sturgeon, Timothy J. 2007. “Conceptualizing Integrative Trade: The Global Value Chains Framework.” In Trade Policy Research 2006, edited by Dan Ciuriak, 35–72. Ottawa, ON: Department of Foreign Affairs and International Trade.

The opinions expressed in this article/multimedia are those of the author(s) and do not necessarily reflect the views of CIGI or its Board of Directors.

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