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Review of Industrial Organization

06.11.2020

Licensing of a New Product Innovation with Risk Averse Agents

Erschienen in: Review of Industrial Organization | Ausgabe 1/2021

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Abstract

An outside innovator invents a new product the viability of which is uncertain. The production technology is licensed to a number (strategic choice) of risk-averse potential Cournot producers by means of: an up-front fee, a per-unit royalty, an ad valorem royalty, or a two-part tariff. The incentive to innovate is maximized with a pure up-front fee if potential producers are (or are close to) risk neutral. Otherwise, it is maximized with a combination of up-front fee and ad valorem royalty. Any scheme that contains a royalty component (per-unit or ad valorem) maximizes the innovation diffusion. Irrespective of the magnitude of licensees’ risk aversion, the innovator and consumers are better off, but licensees are worse off with schemes that have an ad valorem royalty component than with a per-unit royalty component. Consumers are best off with pure up-front fee that avoids double marginalization, even though the innovator optimally sells only one license and creates a monopoly. The results remain similar for a risk-averse innovator, but change considerably with a producing innovator.

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For instance, in a sample of 278 licensing contracts, 78\(\%\) include a royalty, among which 96\(\%\) use ad valorem schemes (see Bousquet et al. 1998). The IFA Educational Foundation and Frandata (2000) reported that 1006 out of a sample of 1226 franchisors charged their franchisees ad valorem royalty, mostly with some level of up-front fee.

For the 160 examples of failed product innovation (including products of Facebook, Amazon, Microsoft, Google, Nike, and others), see https://www.cbinsights.com/research/corporate-innovation-product-fails/.

The assertion that innovation’s diffusion is at maximum for a two-part tariff with ad valorem royalty is established numerically. All other results of the paper are proven analytically (including the proof of maximum diffusion with a pure ad valorem royalty).

However, franchising is different from licensing of innovations in several aspects. First, licensing (franchising) is not the only source of revenue for the franchisor but it is for the innovator. Often franchisors force franchisees to buy raw material from suppliers who in return give franchisors some kickback. Another major difference is in the amount of control the franchisors have with respect to franchisees. Franchisors protect their trademarks and logos and control the business concept.

Blair, R., & Lafontaine, F. (2005). The economics of franchising. Cambridge: Cambridge University Press.CrossRef

Bousquet, A., Cremer, H., Ivaldi, M., & Wolkowicz, M. (1998). Risk sharing in licensing. International Journal of Industrial Organization, 16, 535–554.CrossRef

Colombo, S., & Filippini, L. (2015). Patent licensing with Bertrand competitors. The Manchester School, 83(1), 1–16.CrossRef

Fan, C., Jun, B., & Wolfstetter, E. (2018). Per unit versus ad valorem royalty licensing. Economics Letters, 170, 71–75.CrossRef

Hernandez, M. R., & Llobet, G. (2006). Patent licensing revisited: Heterogeneous firms and product differentiation. International Journal of Industrial Organization, 24(1), 149–175.CrossRef

Hesse, R. (2015). Business review letter from the acting assistant attorney general of the Antitrust Division, US Department of Justice, to Michael A. Lindsay. Institute of Electrical and Electronics Engineers, Piscataway, February 2.

Heywood, J., Li, J., & Ye, G. (2014). Per unit versus ad valorem royalties under asymmetric information. International Journal of Industrial Organization, 37(C), 38–46.CrossRef

IFA Educational Foundation and Frandata Corp. (2000). The profile of franchising. Washington, DC: IFA.

Llobet, G., & Padilla, J. (2016). The optimal scope of the royalty base in patent licensing. The Journal of Law and Economics, 59(1), 45–73.CrossRef

San Martin, M., & Saracho, A. I. (2015). Optimal two-part tariff licensing mechanisms. The Manchester School, 83, 288–306.CrossRef

Sen, D., & Tauman, Y. (2007). General licensing schemes for a cost-reducing innovation. Games and Economic Behavior, 59, 163–186.CrossRef

Teece, D. J. (2015). Are the IEEE proposed changes to IPR policy innovation friendly? Working paper Series No. 2. Berkeley: University of California, Tusher Center for the Management of Intellectual Capital.

Titel: Licensing of a New Product Innovation with Risk Averse Agents
Publikationsdatum: 06.11.2020
Erschienen in: Review of Industrial Organization / Ausgabe 1/2021
Print ISSN: 0889-938X
Elektronische ISSN: 1573-7160
DOI: https://doi.org/10.1007/s11151-020-09797-5