We analyse a dynamic North-South model of innovation, technology transfer, and trade. Northern firms conduct R&D using labour which has alternative uses producing in the R&D sector or a nontraded good sector. Since technology transfer prevents the North from fully appropriating benefits of R&D, the optimal rate of innovation for either profit maximizing firms or a utility maximizing Northern planner is less than globally optimal. An increased transfer rate intensifies competition of lower wage Southern workers with Northern workers in production, so profit maximizing Northern firms (irrespective of their number or cooperation in R&D) reallocate labour toward R&D.