The role of technology security in a model of horizontal differentiation

The security concerns of exporters of products which might be used for military purposes have motivated different security regimes that limit the quality of the products exported by home firms. At the same time however, home governments want to ensure the competitiveness of their home companies. We analyze the optimal policy of a government facing such a trade off. We present a multistage model in which the government has the ability to commit to R&D subsidies but cannot credibly set its quality restrictions until the outcome of the R&D process is known. We show that, depending on whether some or all governments want to restrict the quality exported by the home firms, the optimal policy involves R&D subsidies or taxes together with ex post security restrictions.