A comparison of milestone contract and royalty contract under critical value criterion in R&D alliance

This paper attempts to better understand contract type and risk attitude in R&D alliance under information asymmetry, that is, how the marketer designs and chooses optimal contract between royalty contract and milestone contract and how the innovator’s risk attitude and asymmetric information affect the marketer’s optimal contract strategies and profits. We use principal–agent models to formulate the marketer’s contracting problem under asymmetric information about the innovator’s innovation expertise and unobservable efforts. We find that, compared to the case under full information in both contracting structures, the marketer should distort the commission rate upwards under dual asymmetric information when the innovator is risk averse or downwards to lower innovation–expertise and risk-loving innovator; nevertheless, the marketer should offer the first-best contract. Furthermore, investigating the impacts of information asymmetry on the marketer’s profits under two information structures, we find that dual asymmetric information harms the marketer’s profit, especially when the innovator’s effort marginal efficiency is higher. Finally, by comparing the marketer’s profits in two types of contracts, we give the specific regions that milestone contract or royalty contract benefits the marketer better under different information structures.