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Incumbency 1999

Incumbency 1999

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Published by Joshua Gans
Joshua Gans and Scott Stern, "Incumbency and R&D Incentives: Licensing the Gale of Creative Destruction" 5 August, 1999
Joshua Gans and Scott Stern, "Incumbency and R&D Incentives: Licensing the Gale of Creative Destruction" 5 August, 1999

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Published by: Joshua Gans on Dec 08, 2009
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01/28/2010

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Incumbency and R&D Incentives:Licensing the Gale of Creative Destruction
by
J
OSHUA
S. G
ANS
 
and 
S
COTT
S
TERN
*
 5 August, 1999
 
This paper analyzes the relationship between incumbency and innovative activityin the context of a model of technological competition in which
technologically
 successful entrants are able to license their innovation to (or be acquired by) anincumbent. That such a sale ought to take place is natural since the post-innovationmonopoly profits are greater than the sum of duopoly profits. The model integratesinsights about the economic determinants of licensing fees (such as the size of knowledge spillovers or the sunk costs of product market entry) into the canonical modelof technological competition under uncertainty. In so doing, we identify three keyfindings about how bargaining power during licensing negotiations impacts theincentives to engage in R&D. First, since an incumbent’s threat to engage in imitativeR&D during negotiations increases their bargaining power, our model identifies a purelystrategic incentive for incumbents to develop an R&D capability. Second, incumbentsresearch more intensively than entrants as long as (and only if) their “willingness-to-pay”for the innovation exceeds that of the entrant, a condition that depends critically on theexpected size of the licensing fee. Third, when the expected licensing fee is sufficientlylow, the incumbent considers entrant R&D a strategic substitute for in-house research.This stands in contrast to the prediction of strategic complementarity which arise inpatent races where licensing is not allowed.
 Journal of Economic Literature
 Classification Numbers: Bargaining Theory (C78); Monopolization Strategies (L12);Vertical Integration (L22); R&D (O32).
Keywords
: incumbent, entrant, research and development, innovation, bargaining,preemption, biotechnology, patent race.
*
Melbourne Business School, University of Melbourne, and MIT Sloan School and NBER, respectively.We thank seminar participants at Stanford, Virginia, MIT, Queensland, and the Australian NationalUniversity; and conference participants at the Australasian and North American Meetings of theEconometric Society and the Technology and the Organization of Industry Conference at the University of Urbino for helpful comments. Rebecca Henderson, Jorgen Pedersen, Rohan Pitchford, and SuzanneScotchmer provided many useful suggestions. Financial assistance from a Special Initiatives Grant at theUniversity of Melbourne is gratefully acknowledged. Responsibility for all views expressed remains ourown. All correspondence to: Scott Stern, MIT Sloan School, E52-554, Cambridge, MA 02142; Fax: 617-253-2660; E-mail: sstern@mit.edu.
 
2
Incumbency and R&D Incentives:Licensing the Gale of Creative Destruction
5 August, 1999
 
This paper analyzes the relationship between incumbency and innovative activityin the context of a model of technological competition in which
technologically
 successful entrants are able to license their innovation to (or be acquired by) anincumbent. That such a sale ought to take place is natural since the post-innovationmonopoly profits are greater than the sum of duopoly profits. The model integratesinsights about the economic determinants of licensing fees (such as the size of knowledge spillovers or the sunk costs of product market entry) into the canonical modelof technological competition under uncertainty. In so doing, we identify three keyfindings about how bargaining power during licensing negotiations impacts theincentives to engage in R&D. First, since an incumbent’s threat to engage in imitativeR&D during negotiations increases their bargaining power, our model identifies a purelystrategic incentive for incumbents to develop an R&D capability. Second, incumbentsresearch more intensively than entrants as long as (and only if) their “willingness-to-pay”for the innovation exceeds that of the entrant, a condition that depends critically on theexpected size of the licensing fee. Third, when the expected licensing fee is sufficientlylow, the incumbent considers entrant R&D a strategic substitute for in-house research.This stands in contrast to the prediction of strategic complementarity which arise inpatent races where licensing is not allowed.
 Journal of Economic Literature
 Classification Numbers: Bargaining Theory (C78); Monopolization Strategies (L12);Vertical Integration (L22); R&D (O32).
Keywords
: incumbent, entrant, research and development, innovation, bargaining,preemption, biotechnology, patent race.
 
I. Introduction
Many research-oriented start-up firms earn their economic returns on innovativeinvestments through cooperative arrangements with established, incumbent firms. Thispattern of interaction between potential entrants and incumbents sharply contrasts withthe (much-studied) Schumpeterian perspective – where innovation-driven entrants are themechanism by which the “gale of creative destruction” is unleashed on entrenchedmonopolists. Motivated by the phenomena of cooperative arrangements betweenincumbent and entrants, the main goals of this paper are to evaluate (a) how the rentsfrom innovation will be divided in an economic environment where cooperativeagreements are feasible and (b) how the prospect of a “market for ideas” affects the R&Dinvestment incentives of both incumbents and research-oriented start-ups.Product market cooperation between incumbents and potential entrants occursacross industrial sectors and takes many forms, from simple technology licensing toproduction/marketing alliances to outright acquisition of the start-up by the incumbent.While the motivation for this paper is on the
general
choice of cooperation versuscompetition, our exposition focuses on technology licensing as the means by whichcooperation is achieved. This allows us to evaluate how licensing fees – a usefulrepresentation of the potential entrant’s rents from cooperation – are determined andimpact R&D incentives.Consider the biotechnology industry. While a small minority of biotechnologyfirms have integrated into the manufacture and distribution of new drugs, nearly all

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