Licensing a product innovation in a duopoly

This paper studies the licensing of a product innovation in a duopoly by means of two-part tariff contracts composed of fixed-fee payments combined with per-unit or ad-valorem royalties. When the licensor is a firm within the industry (internal licensor), it licenses the innovation to its competitor by using a pure ad-valorem royalty, and welfare is reduced because the royalty has anticompetitive effects on market performance. On welfare grounds, fixed-fee predominates over per-unit royalty licensing, but has the disadvantage that firms sometimes fail to reach an agreement. A simple regulatory rule is then proposed for a second-best optimal policy on product innovation licensing. However, when the innovator is outside the industry (external licensor), it never uses ad-valorem royalties. Also evaluated is the value of the innovation for an internal and an external innovator, and licensing by both innovators under Bertrand competition.