Licensing of a cost-reducing innovation in a Stackelberg-differentiated duopoly

Abstract

This study investigates the licensing of a cost-reducing innovation by a firm to its direct competitor in a Stackelberg-differentiated duopoly. We find that the licensor's market position coupled with the product's nature and innovation size play an important role in framing the licensing agreement and its welfare impact. When acting as the market leader in determining output, the licensor offers its competitor a pure ad valorem royalty contract if the products are close substitutes for each other or if the innovation is sufficiently large in the case of distant substitutes; otherwise, a per-unit royalty combined with a fixed fee is preferred. However, if the licensor acts as a follower in the product market, the licence comprises a per-unit royalty, sometimes combined with a fixed payment. Compared with the pre-licensing context, licensing by a market follower is never welfare-reducing, whereas licensing by a market leader is only welfare-reducing when products are extremely close substitutes. Optimal licensing with complementary products is also studied, which could result in a per-unit subsidy.