1

Preliminary - Comments Welcome

Incumbency and Competition in Innovation Markets**

by

JOSHUA S. GANS and SCOTT STERN*

First Draft: 3 June, 1997

This Version: 27 June, 1997

Economic analyses of the impact that concentration in product markets

has on innovation in those markets has not, to date, generated clear
predictions as to how such concentration influences the pace of innovation.
We argue that economic theory has neglected the possibility, and indeed
likelihood, of licensing by or acquisition of entrants by incumbents. By
considering this more complete picture of reality, we argue that regulatory
uncertainty over licensing and acquisition of entrants has an direct effect on
innovation incentives of entrants and through this a strategic effect on
incumbents. These effects are particularly telling if entrants are more
productive than incumbents for organisational or incentive reasons. Second,
there is no reason to suppose that rapid opportunities for innovation will
reduce market power in downstream product markets. Instead, the critical
conditions rely on the relationship between innovation and the creation of
information asymmetries between incumbents and entrants. Third, the
possibility of cannabilisation of incumbent assets can potentially create
greater disincentives for entrants than for incumbents. Finally, the pre-
emption effects that have raised anti-trust concerns do not matter when
licensing is possible.

**
This paper was prepared for the Australian Law and Economics Association Annual Conference,
University of Melbourne, 4-5 July, 1997. We thank Peter Cebon for helpful comments on an earlier draft
of this paper.
*
University of Melbourne and MIT, respectively. All correspondence to: A/Prof. Joshua Gans, Melbourne
Business School, 200 Leicester Street, Carlton, Victoria, 3053, Australia; E-mail:
J.Gans@mbs.unimelb.edu.au; Fax: +61-03-9349-8133. The latest version of this paper is available at:
http://www.mbs.unimelb.edu.au/home/jgans.
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There is a long standing concern in economics regarding the interaction between

innovation and market structure. To this end two key, related classic questions have been

posed:

• What are the relative incentives of incumbents and entrants to generate innovations?

• How does successful innovation itself influence market structure?

Since Schumpeter these questions have been seen as intimately related. That is, an answer

to the first question determined the answer to the second. If it was argued that incumbents

were more likely to generate innovations than entrants, then it could be equally argued that

monopolies would persist in the post-innovation market. On the other hand, it was

predicted that markets would become more competitive over time if entrants had greater

innovation incentives than incumbents.

The close relationship between these questions comes from an implicit assumption

about the link between successful innovation and product market entry. In particular, as

depicted in Figure One, it was assumed that successful innovation by an entrant led to entry

into the product market and that no entry would otherwise occur. In effect, this amounts to

two assumptions: (1) that innovation is the springboard of entry; and (2) that entrants with

innovations must enter product markets to realise the returns from their innovation.

Figure One: Traditional Conception

Innovation
Race

Product Market
Competition
 3

The starting premise of this paper is to challenge this view of the relationship

between innovation and product markets. In so doing, we argue that the tight linkage

between the two classic Schumpeterian questions is misplaced. Our challenge rests on the

notion that successful independent researchers have options other than product market entry

that can assist them in deriving commericial value from innovations (see Teece, 1987). In

particular, patentable innovations can be licensed to product market incumbents or,

alternatively, independent research teams can themselves be acquired by incumbents.

When independent research teams lack the complementary assets to become product market

entrants, prima facie, this integration with incumbents will not have anti-competitive

effects. Given the availability of these options, the appropriate framework for addressing

the Schumpeterian questions is as in Figure Two, where licensing and acquisition as well

as product market competition is an option for independent researchers.

Figure Two: Our Conception

Innovation
Race

Bargaining and
Negotiation

Product Market Licensing or

Competition Acquisition
 4

When a cooperative arrangement such as licensing or acquisition is possible, if

independent research teams generate innovations prior to an incumbent’s in-house research

team, it is in both its interests and those of incumbents to consider such options prior to any

product market entry. The common incentives are twofold. First, by licensing rather than

entering into product market competition, the sunk costs of such entry are saved. Second,

there are mutual gains to preserving a monopoly in the product market -- that is, the sum of

duopoly profits that could be earned in an industry is typically less than the profits of a

monopolist. For this reason, the independent research team and incumbent will engage in

bargaining and negotiations prior to exercising the options designed to yield an

innovation’s commerical value. This stage is depicted in Figure Two.

It should be noted that it will normally be the case that bargaining and negotiations

will not take place prior to an innovation race. While one can imagine that an incumbent

might enter into some contractual arrangement with independent researchers, because of the

uncertain nature of the innovative activity, it will be difficult to do more than specify rights

over potential output while ensuring that the research team is truely independent (Aghion

and Tirole, 1994). Therefore, an independent team will be distinguished from an in-house

research team on the basis of who owns the innovation after it is generated. That is

precisely the distinction we adopt for the purposes of this paper. An independent research

team is independent in the sense that it owns an innovation and, if it has the capability, can

either license to or become a potential competitor to the incumbent.

Viewing the innovation process from the perspective of Figure Two has profound

implications for the way in which we look at the economics of technological change. In

one instance, it more accurately portrays the process by which innovations come to

generate economic value for researchers. This is demonstrated in Section I using

andecdotes from biotechnology, computer software and telecommunications. But, more

critically, in the absence information asymmetries or transactions costs associated with the

bargaining stage, successful product market entry by independent researchers

 5

represents an economic puzzle. When there are no impediments to efficient or Coasian

bargaining, independent researchers will exercise their option to license or become acquired

by incumbents rather than become their direct competitors. This means that, even if

independent research teams were to have greater innovation incentives than incumbents,

this would not, in of itself, allow us to reach the conclusion that markets will become more

competitive over time. Thus, consistent with anecdotes in Section I, in Section III we

argue that licensing rather than product market competition is to be expected, although the

spectre of potential product market competition might influence the division of innovation

rents between incumbent and entrant.

The expectation of licensing alters the rents that incumbents and entrants can hope

to gain from innovative activity. While previous formulations of technological competition

have found it difficult to predict when incumbents as opposed to entrants will innovate

first, we demonstrate that when licensing is expected, clear predictions are possible. In

particular, when independent research units face high sunk costs of entry into product

markets, incumbents will in fact research more intensively than independent teams. This is

because, when there are no strategic considerations, incumbents are willing to pay more for

innovations than independent teams. Strategically, both incumbents and independent teams

are motivated to pre-emptly innovate before the other, but this driving force is the same for

each. When an independent research team innovates first it gains the expected license fee

from the incumbent, while the incumbent’s incentive to innovate first is driven by its desire

to avoid this same fee. Therefore, only their relative willingness to pay can explain

differences in their incentives.

This paper will present a series of results that have implications of antitrust policy.

In so doing, we will not focus on formalisms. We refer readers to another paper for these

(see Gans and Stern, 1997). Instead, we will rely on simple examples to explain how the

possibility of licensing affects the nature of technological competition and, in particular,

thoughts about how incumbency influences the innovative process.

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II. Motivating Cases of Technological Competition

The main insights of this paper arise from the fact that we allow entrants to license

and/or integrate with incumbents. Indeed, the main prediction of ours is that when the

main sources of uncertainty are technological in nature (so that a proven technology’s

economic value is agreed upon by all agents) and firms are maximising the financial returns

from their intellectual property, independent research firms should never invest resources

into manufacturing; we should not observe instances of entrants competing with

incumbents in the product market. Certainly this is a strong prediction; however, our

analysis of technology-intensive sectors suggests that the pervasiveness of licensing and

acquisition are underemphasised in most economic treatments of technological competition

between entrants and incumbents.1 To evaluate this claim more fully, we motivate our

analysis through three extremely well-known instances of innovative investment. Our main

objective in examining these cases is to motivate the examination of a model in which

licensing is feasible and to highlight the observed patterns of investment and contracting

that result.

Eli Lilly and the “Patent Race” for Human Insulin

Among empirical instances of technological competition, perhaps none has been

more intensively studied than the “patent race” for human insulin which occurred in the late

1970s (a popular account of this research is provided in an entertaining book by Hall

(1988)). Closely watched at the time by industry observers and public policy makers, the

development of a human insulin product represented the first commercially-oriented

product in the novel field of “biotechnology;” as such, innovative investments towards that

development goal were closely watched and the scientific and commercial issues which

1
More precisely, our claim is that the realized gains from innovation by independent researchers (i.e., those
without established product market assets prior to the innovation) arise primarily from licensing to and/or
 7

arose set the context for debates about the proper use and organization of biotechnology

research (for a useful summary of these debates, see Krimsky (1982)). In the twenty years

since the successful development of insulin by the start-up firm Genentech, the case of

human insulin has been used again and again as an example to motivate different models of

technological competition (for instance, the main case used to explain technological

competition and patent races to business school students is The Race to Develop Human

Insulin (Parese and Brandenberger, 1992)).

Most analysts date the commencement of this case of technological competition to a

research conference hosted by Eli Lilly in May, 1976. As the world’s leading producer of

insulin for diabetics, Lilly arranged the conference to assess whether novel recombinant

DNA tools could be utilized to produce human insulin, providing a quality-improving

substitute to the pork and beef insulin that had been used historically in the treatment of

diabetes. While molecular biologists were extremely excited by the possibilities of rDNA

from a scientific perspective, few analysts or scientists expressed a belief that there would

be important commercial applications in the near future; moreover, most of the main

researchers were employed by universities, limiting their incentives and opportunity to

explore commercial applications.

The Lilly research meeting, along with continued encouragement by Lilly in the

form of research funding and commitments to license commercialisable technology,

provided researchers with new information that financial returns could be realised through

the application of the new scientific tools. As a result, three separate research teams

pursued programs aimed at the “expression” of the insulin gene (a necessary condition for

commercial exploitation of the rDNA techniques). Two of the teams, based at the

biology/biochemistry deparments of Harvard and UC-SF, were essentially university

research labs diverting attention and resources away from purely scientific projects and

acquisition by established firms and that the decision to invest resources towards invention depends, in large
part, on the expectation of these licensing and/or acquisition rents.
 8

towards the commercially relevant human insulin project. The third team was initiated by

Genentech, a start-up biotechnology firm founded by an entrepreneur (Bob Swanson) and

a scientist (Herbert Boyer), which operated outside of the confines of a university research

lab.

According to all accounts of the research, each of these three teams was aware of

the investments by the others and acted to “pre-empt” the other teams’ research success.

For example, the UC-SF research team violated NIH rules regarding the use of genetic

materials in their experiments; this type of violation was serious enough so that a leading

researcher speculated that “Capitalism sticking its nose in the lab has tainted interpersonal

relations…the UCSF team was in competition with a group at Harvard which was known

to be working with better source material.” (David Martin, quoted in Wade, 1977, p.

1342). As well, the Harvard team, headed by Walter Gilbert, chose to discontinue support

for a well-regarded graduate student, Forrest Fuller, precisely because Fuller was unable to

successfully contribute to his assigned portion of the commercialisation project (see Hall,

1988, pp. 176-178).

Perhaps most telling, Genentech chose to pursue an alternative research strategy –

gene synthesis – which was more amenable to commercialisation prospects because it was

not subject to burdensome NIH regulations governing the use of genetic materials. Despite

the use of this alternative approach, the possibility of pre-emption was one of the most

important tools used by Genentech management in motivating their researchers. As

recounted by Roberto Crea, one of the principal Genentech scientists, “Definitely the name

of Wally Gilbert was in Swanson’s mouth all the time. That we had to beat

him…Swanson used that as a management tool to keep pressure on Goeddel, knowing that

Goeddel was so competitive.” (Roberto Crea, quoted in Hall, pp. 219)

Under the threat of preemption, each research team pursued human insulin until

August, 1978, at which time Genentech researchers were able to successfully synthesise

the human insulin gene in bacteria, opening the door to the first commercial application of
 9

biotechnology. One day after their experiment was validated, Genentech signed an

exclusive license agreement with Eli Lilly which granted Lilly the manufacturing rights to

Genentech’s intellectual property and contracting with Genentech for collaboration on

certain of the scale-up activities for which Genentech would have greater expertise. One of

the distinctive feature of the negotiations around this license is that, despite Lilly’s

encouragement of the research, Lilly turned out to be an extremely strong negotiator, de-

emphasising Lilly’s need for the technology (they could continue to use animal insulin) and

discounting claims by Swanson of the viability of the product (Hall, p. 23*).

The irony of this case is that the realised gains from this research investment came

in the form of a license to the incumbent – Eli Lilly. Most prior economic models of

technological competition which evaluate the relative R&D incentives of incumbents and

entrants exclude this possibility by dictating competition in the product market after the

realisation of the innovation. While Lilly did pursue a research program, Lilly’s main

investments were focused towards encouraging research by independent researchers,

confident that successful innovations could be licensed and that the independent research

teams would be in a relatively weak bargaining power in negotiations.

What is perhaps most interesting about this case is that it is, by all accounts, not

unique for the biotechnology industry. Except for a small number of exceptions,

biotechnology firms either became licensors of their technology to a large established firm

(which retained responsibility for FDA approval procedures, marketing, etc…) or were

purchased outright by such a firm through an acquisition. As noted by Orsenigo, “the

NBFs, born to exploit commercially their unique skills in the new technologies, attempted

to integrate forward and to acquire capabilities in production but, in most cases, became

specialized suppliers of very specific technical know-how.” (Orsenigo, p. 145). Indeed,

despite a “radical” change in the scientific underpinnings of pharmaceutical research and

waves of entry by independent research firms attempting to exploit these scientific

opportunities, there has been little change in the downstream sales leadership of
 10

pharmaceutical products (excluding mergers and acquisitions between companies)

(Henderson and Cockburn, 1996; Gambardella, 199*). Instead of sustained waves of

displacement of incumbents, the set of incumbents has remained relatively constant and the

incentives for entry for independent firms has been the expectation of being acquired by

one of these incumbent firms.

Microsoft and Fox Software

Of course, the case of biotechnology might be considered an anomaly; patent

protection is strong, the importance of taking advantage of university-based science is

paramount in the research process, and established pharmaceutical companies have strong

incumbent positions in most major therapeutic markets. However, several of the same

features of the interaction between incumbents and entrants can be observed in the

computer software industry, and, in particular, in the internal research and acquisition

strategy of Microsoft.

Consider the case of the Foxpro database. By March 1992, Microsoft had grown

to be the leader in the PC software industry, with its virtual monopoly over the operating

system market (Windows 3.1) and a strong position in several important applications

markets, including spreadsheets (Excel) word processors (Word) and presentation graphics

(Power Point). However, it had not yet introduced a database application into its product

portfolio. Thus, Microsoft possessed a set of assets which would be complementary with

a database offering but had not yet exploited this complementarity. As a $600 million

market, the PC database market leader was Borland/Ashton-Tate (having recently

completed a merger), with Fox Software’s FoxPro database (a dBase clone) controlling

only a small portion of the market (12% market share).

For several years, Microsoft had been explicitly pursuing a two-pronged strategy

towards getting into the database market. On the one hand, as early as 1987, Microsoft had

been developing its own database program internally, codenamed Omega. At the same
 11

time, Microsoft pursued Fox as an acquisition candidate. For example, in November

1989, officials from Microsoft had met with Fox in order to present Omega and inquire

about Fox’s interest in collaboration and/or acquisition (at that time, Fox was essentially an

entrant with little experience in marketing, distribution and support of software products).

Microsoft executives were impressed by Fox’s product but were unwilling to provide Fox

with an attractive enough offer to merge. The failure of this early merger proposal was

due, in part, to Microsoft’s aggressive bargaining and its description of Omega as a viable

alternative to Fox’s technology.

While a disagreement over the relative value of each other’s technology hampered

an agreement in 1989, the strong economic incentives for integration resulted in continued

interest and discussions between the two firms for several years. During that time,

Microsoft additionally developed a new database product (code-named Cirrus and

introduced as Access) which was more differentiated from FoxPro. As well, FoxPro

obtained modest success in the product market (with the third most popular product) while

fighting a legal battle over whether its products violated the intellectual property of Ashton-

Tate. Within weeks of the resolution of this legal battle (decided in favor of Fox),

Microsoft and Fox merger discussions again gained momentum resulting in the March,

1992 announcement of an agreement valued at around $175 million.

According to the CEO of Fox Software, David Fulton, the incentive for merger

arose from the fact that Fox “just haven’t had the resources,” to successfully compete in the

product market. On the other hand, Charles Stevens, Microsoft’s database program

manager, suggests that the acquiring firm’s incentives were that “we needed a competitive

database product…not just an adequate product.” (Stevens, quoted in Pallatto, p.89).

Interestingly, many observers suggested that Microsoft had paid “too much” for FoxPro;

Microsoft’s stock price fell on the news of the merger. While the particular terms of the

agreement might be controversial, the incentive for merger is clear; FoxPro had few assets
 12

which could be used to market their superior technology while Microsoft’s internal

development was not as successsful or as productive as the entrant.

Once again, the important point of this case is that its fact pattern is the norm rather

than the exception. Starting in the early 1990s and intensifying more recently, Microsoft’s

acquistion strategy has been aggresively focused on small firms serving market segments

which are related to but not in direct competition with current Microsoft products (see

Gawer, 1997, for additional evidence on the types of “skimming” undertaken by Microsoft

and other established players in the PC market (Intel, Adobe, etc). For example, in 1996,

Microsoft bought or invested in 20 companies (valued at over $1.5 billion). Much of this

investment is focused on Internet-related corporations, including recent purchases of

Vermeer Technologies, forerunners in World Wide Web publishing software; eShop Inc.,

a leader in Internet commerce technology; and NetCarta Corporation, which develops

client/server Web management and navigation technology. As a result of these focused

investments in acquiring companies which are potential competitors with fewer incumbent

assets at their disposal, Microsoft has attained the position of being one of the largest (if not

the largest) acquirer of small companies in the world.

Bell & Western Union 1877-1879.

Finally, we will take a much-studied example from business and technological

history – the case of the Bell System. As all (US) school children know, Bell started out as

an independent researcher (with Bell attaining the mythic status of the successful “tinkerer”

with his March 10, 1876, invention of the telephone); from these beginnings, the Bell

System integrated into the manufacture and distribution of telephone equipment and

service, eventually becoming the world’s largest private corporation for much of the post-

World War II era. Along its way towards monpoly status, Bell displaced the incumbent

firm Western Union, which maintained a near-monopoly on telegraph service at the time
 13

the telephone was invented (Smith (199*) provides a detailed history of the early Bell

system).

At first glance, Bell’s integration into the product market (both in the production of

telephone equipment and telephone service) seems to contradict our main claim – that the

rents from innovation by independent firms comes through the licensing of the technology

to (or wholesale acquisition of the firm by) established, incumbent firms with product

market assets. However, this failure to integrate highlights the economic forces underlying

our theory even more strongly. In particular, the early history of the Bell system was

characterised by a series of attempts to sell their intellectual property (and in fact the firm)

to Western Union.

Less than a year after the first telephone conversation, Thomas Sanders, the main

backer of Alexander Graham Bell’s inventive efforts (and his father-in-law), pushed the

firm to make an offer to sell the full rights to the telephone system to Western Union for

$100,000. While Sanders believed that the telephone was a viable commercial technology,

he believed that Western Union would be able to use this technology more effectively and

that, unless an agreement could be reached, Western Union would “crush us by fair means

or foul.” Sanders went so far as to argue for “coming to an agreement with this powerful

combination,” even if it meant selling the business. At the time, Western Union controlled

the intellectual property with potentially competing claims of the Bell System (Elisha

Gray’s famous “second” telephone patent application and intellectual property acquired

from Thomas Edison related to microphonic transmission). As well, Western Union

maintained a cadre of internal researchers whom were believed to be able to supplant the

Bell technology through internal development. With these assets in place and with internal

estimates of the value of the telephone which were not nearly as favorable as those held by

the Bell patentholders (with internal Western Union documents labeling the invention a

mere “scientific curiousity”), Western Union president William Orton (under the direction
 14

of William Vanderbilt) refused the Bell offer, leaving the Bell patentholders to compete

with them in the product market.2

As predicted by Sanders, the Bell Company (the first name of the corporation) was

relatively unsuccessful in its competition with Western Union. First, with no assets in

place, National Bell’s financial returns to the telephone became limited to license fees

received from two sources: regional entrepreneurs who were granted exclusive rights to set

up local telephone services in given geographical regions, and Charles Williams, an

established electrical manufacturing firm which received an exclusive license (subject to

meeting capacity) to manufacture Bell’s telephone equipment (selling it to the regional

licensees). Moreover, despite controlling the most important piece of intellectual property

and providing high-powered incentives to its licensees, the National Bell system’s growth

by 1879 (only 18 months later) was slower than that of Western Union, which had

essentially “beaten” Bell in several key cities, including New York and Chicago.

At this time, Gardiner Hubbard (the other initial financial backer of the company

who expressed a desire to maintain the company under his own control) was replaced by

William Forbes (a main source of new capital of the firm) who placed Theodore Vail as

general manager of the firm in May, 1879. Vail and Forbes, renaming the company the

National Bell Telephone Company, quickly undertook to rework the firm’s licensing

strategy and renewed negotiations with Western Union. Each side agreed that eliminating

competition and duplicative investment would substantially increase profits and that Bell

and Western Union patents and organisation had to be pooled “in order to enable

everybody to use good telephones.” However, in contrast to 1877 when negotiations

faltered over the value of the technology and the security of Bell’s intellectual property, the

negotiations in 1879 were between two firms both of whom had incumbent assets based on

their experience in the market in the prior two years. Moreover, Bell still maintained the

2
Note that the main financial backer of Bell argued for an agreement at a lower price, while it was the
individuals whom were involved in running the buiness – Hubbard in particular – who argued against
selling the business at a lower price.
 15

primary intellectual property claim (and Western Union lawyers had acceded to this claim

by 1879). Perhaps most importantly, Bell had the threat of an outside merger with Jay

Gould, who was (for reasons which had more to do with spirited warfare on the New York

stock exchange than anything else) investing in a telegraph network of his own to compete

directly with Vanderbilt’s Western Union.

As it turned out, this favorable negotiating position for National Bell (brought about

largely by circumstances beyond their direct control) led them to be able to conclude the

justly famous Bell-Western Union Patent Agreement of 1879. Essentially, Bell and

Western Union exchanged intellectual property and product market assets so that each

could maintain a monopoly in their respective segment. If Bell stayed out of the telegraph

business, Western Union would stay out of the telephone business. On the news of this

agreement to ensure monopoly and avoid duplicative investment, Bell’s stock rose to over

$1000 per share; during the era of competition with Western Union, the stock had hovered

at approximately $50 per share.

Taken together, these cases provide some (admittedly informal) empirical evidence

for the importance of licensing and/or acquisition in technology-intensive markets, and, in

particular, in the interactions between incumbents and entrants. In each of the cases

considered, the incumbent firm considered acquiring or licensing technology from the

independent research firm and all agents recognised that the gains from merger would arise

from the advantage of incumbent sunk assets and the ability to avoid competition in the

product market. At least for these three markets – biotechnology, computer software, and

telecommunications – evaluating the relative incentives for innovation by incumbent and

entrants cannot be disentangled from the financial returns each expects to receive contingent

on the successful licensing of the technology. In other words, Microsoft’s R&D

investments in applications software are made in the awareness of potential competition as

well as the expectation that competition can be substantially muted through licensing and
 16

acquisition. While previous work has argued that licensing is an important element of

technological transfer (Anton and Yao, 1994; Arora and Gambardella, 1995), our argument

is much more restrictive; in the absence of asymmetric information between incumbents and

entrants, the absence of licensing is an important economic puzzle from the viewpoint of

models of technological competition.

II. Basic Framework and Assumptions

Before turning to the main results from the paper, we must state more precisely the

basic framework and assumptions we are relying upon. Here we suppose that innovative

activity is directed towards a single product innovation. If the incumbent monopolist

develops this product innovation, it adds to their portfolio and potentially raises its

profitability by allowing them to exploit the increased demand that results. To represent

this, let π m (θ ) be the present value of the incumbent’s monopoly profits when it does not

have access to new product and π m (θ ) if it does. This latter value remains the same

regardless of whether the incumbent has generated the innovation themselves or acquired it

from an independent research team. We assume that:

ASSUMPTION 1: π m (θ ) ≥ π m (θ ) .

In contrast, if the entrant develops the innovation and chooses to enter into product market

competition with the monopolist, both the incumbent and entrant receive symmetric profits,

π d , although the entrant must incur an additional sunk cost of K before being able to start-

up production. We assume that:

ASSUMPTION 2: π m (θ ) ≥ 2π d .

The sum of duopoly profits is less than the monopoly profits of the incumbent. This is a

common assumption in economics and, in particular, in work on technological competition

(Gilbert and Newbery, 1982).

 17

A final set of assumptions concerns the incentives for product market competition if

an incumbent generates the innovation first. We want to consider situations in which

incumbents can actually pre-empt product market entry by generating an innovation. In the

patent race literature, this assumption is implicit as property rights are always assumed to

be strong. As will be discussed shortly, we potentially allow property rights on innovation

to be weak. Entrants or incumbents can potentially develop or imitate innovations

generated by others. To forestall the possibility of product market competition in the event

an incumbent acquires an innovation before the entrant begins production we assume that:

ASSUMPTION 3: Duopoly profits for the entrant when the incumbent is able to produce the
new product are less than K, the sunk costs of entry.

Therefore, if an incumbent innovates first or if it acquires the innovation from an

independent research team, further entry into the product market is not profitable.3,4

The Strength of Intellectual Property Rights

Much discussion regarding technological competition presumes that when one firm

generates an innovation, it can obtain a patent on that innovation and exclude others from

the economic returns associated with it. While this accurately describes high technology

industries such as biotechnological and pharmaceuticals, it is less applicable in industries

such as computer hardware and software.

In those industries, property rights are potentially weak. Innovations might simply

not be patentable. This could occur for several reasons (Anton and Yao, 1994). Some

innovations are too close to existing products. Alternatively, some innovations that are

conceptual and intangible cannot be patented. Even if products can be patented there is the

3
We also implicitly assume that it is not mutually profitable for entrants, having begun production, to
license the innovation to their competitors. That is, the sum of duopoly profits when both firms can
produce the new product are less than the sum of duopoly profits when they have different product sets.
This is a simplification only and all the results to follow would remain the same if we relaxed this
assumption.
4
We are assuming throughout this paper that once an entrant starts up production this decision cannot be
reversed by an agreement between incumbent and entrant. This would be blantantly anti-competitive and
unlikely to be allowed under the usual assumptions of anti-trust law.
 18

possibility that others could find ways to “work around” (Teece, 1987) the patent and

develop products that yield similar economic value. Patentable innovations can be pursued

in distinct ways, but the innovations generated along such paths are perfect substitutes in

terms of their economic value.

Throughout this paper, we will contrast the cases of strong and weak property

rights. Given assumption 3, incumbent acquisition of the new product will, in either case,

preclude further entry into the product market. However, when there are weak property

rights, independent research teams will not be able to preclude incumbent generation of a

similar product innovation except by starting-up production themselves.

Research Technology and Innovation Incentives

We adopt a view of the process of innovation common in the economics literature.

This view is a dynamic one where firms expend costly research effort over time in the hope

of generating an innovation. However, the process of research is uncertain. That is, while

concentrated more effort in a short period of time increases the likelihood that a firm

generates an innovation at that time, it does not guarantee it. Moreover, additional units of

research effort in a period raise the probability of innovating by an increasingly lower

 19

amount.5 Therefore, in the absence of countervailing incentives, firms would wish to

smooth their research effort over time.

There are two forces that pull against this smoothing incentive, each by causing

firms to value generating innovations sooner rather than later. First, when interest rates are

positive, firms prefer profits today above the same level of profits in the future. Hence, by

intensifying their research activity, they raise the likelihood of generating an innovation

earlier and hence, earning the rents from that innovation earlier. We call this a firm’s

willingness to pay for timely innovation. On the other hand, firms potentially have a

strategic incentive to innovate quickly. As first pointed out by Gilbert and Newbery

(1982), by generating an innovation sooner, firms can pre-empt their rivals. This pre-

emption incentive is simply the difference between winning and loosing an innovation

race. We will analyse these in more detail when we come to discuss the innovation race in

Section IV below.

III. Bargaining Over the License and Acquisition Fees

Having stated the basic framework and assumptions we will be considering, it is

now time to turn to what happens in the event an independent research team innovates prior

to the incumbent. We have already assumed that the incumbent will, by innovating first,

pre-empt further activity on the part of the entrant and the monopoly will persist.

However, when independent researchers are the pioneers, they and the incumbent begin

negotiations over whether the innovation will be “sold” to the incumbent and in particular,

at what price.

5
That is, if x is the amount of research under taken during a period and h(x) is the hazard rate denoting the
probability that an innovation is generated in that period, we assume that while h(x) is increasing, it is also
concave. See Reinganum (1984).
 20

Strong Property Rights Case

Consider first the case of strong property rights. An independent research team has

generated and patented the new product. The incumbent cannot develop a close substitute

as this would infringe the independent team’s patent. They, therefore, have a common

interest in negotiating a licensing agreement. This involves establishing the price or license

fee that, if paid, will give the incumbent a right to supply the new product. If an agreement

is reached, the incumbent need not be concerned about future entry given assumption 3.

Therefore, the incumbent can be assured of earning π m (θ ). The net value of the

innovation to the incumbent is, therefore, π m (θ ) − π m (θ ) . This is also the incumbent’s

maximum willingness to pay for the innovation. As such, any agreement will involve a

license fee, τ , equal to some proportion, α , of the net value of the innovation, i.e.,

τ = α (π m (θ ) − π m (θ )) .

How does such an agreement arise? While there are many game theoretic models of

bargaining, a well regarded approach is to view two parties as engaging in negotiations

over time with each having opportunities to make and respond to offers by the other. Each

party realises that while an acceptance of an offer brings about an immediate ability to

realise the returns from their exchange, rejected offers bring delay and more haggling.

Both parties have an interest in minimising any delay but they also wish to gain a greater

share of the rents involved. So when a party has been made an offer it must weigh up the

price they are offered with the possibility of making a more favourable counter-offer, albiet

a delayed one, if it were to reject that offer. Offerors realise this and take it into account

when making their offer. The result is that, in equilibrium, the initial offer made is

accepted immediately and α is determined by each parties relative patience. For instance, if

both parties were equally patient we would expect α = 12 , while if say the incumbent was

more patient than the entrant α < 12 . Factors that make the incumbent more patient

relative to the entrant will lower the expected license fee from negotiations.
 21

This conclusion must be qualified, however, by the spectre of product market

competition. It is possible that an entrant, if it does not expect a reasonable license fee,

might choose to enter into production. In this case, it earns π d − K . Therefore, it will not

accept offers less than this amount and hence, incumbents will need to offer them at least

this. If π d − K is low or negative, this will not constrain the outcome of bargaining.

However, for a higher π d − K , it could be the case that π d − K > α (π m (θ ) − π m (θ )). As

such, we would have τ = π d − K . In general, the negotiated license fee could be

unconstrained or constrained by the possibility of product market competition with:

[ ]
τ = max α (π m (θ ) − π m (θ )), π d − K .

In either situation, the result of bargaining is expected to be an immediate agreement with

the initial offeror (be it incumbent or entrant) offering and the other party accepting τ.

Weak Property Rights Case

How does this outcome change when property rights are weak? The incumbent

now has the ability to fruitfully continue research during negotiations and hence, generate

an innovation and appropriate all the returns for themselves. Given that they have not

begun production, this event leaves independent researchers without an avenue to earn any

rent. This advantage makes incumbents relatively more patient during negotiations. In

order to be persuaded to accept an offer, incumbents must be offered enough to compensate

them for their option value of continued research. Therefore, the stronger the incumbent’s

ability to credibly continue research during negotiations, the lower will be α and hence, τ .

Moreover, weak property rights mean that incumbents can research after product market

entry, potentially generating a product innovation that is a closer substitute with the

entrant’s profit and lowering expected entry profits, π d − K . So in both the unconstrained

and constrained cases, weak property rights mean that incumbents can be expected to

appropriate a greater share of the rents from innovation.

 22

It is important to note, however, that incumbents have a motive to generate an

innovate capability that is purely strategic in nature. When property rights are weak, by

having an innovative capability, the incumbent is able to credibly threaten to continue

research during negotiations and hence, move a greater share of the rents in its favour.

This might occur even if it is relatively inefficient at research. Therefore, strategic

considerations alone might cause a misallocation of research resources to incumbents.

Observed Entry is Unlikely

Regardless of the strength of property rights, the overall result from the bargaining

game involves the independent team licensing or entering into a cooperative arrangement

with the incumbent rather than become direct competitors of each other. Independent

innovation has no ultimate effect on market power, because, despite their conflicting

interests in capturing a share of innovation rents, their common interest in gaining an

agreement with minimal delay ensures wins out. It is only when there is some impediment

to this bargaining process -- such as asymmetric information or other transaction costs --

that we might see successful new entry into product markets. We will discuss this

possibility further in Section VI. But even then, the result of bargaining breakdown might

be licensing to another, perhaps smaller incumbent. In this interpretation, K represents the

costs that other incumbent faces in developing the product innovation. In this respect, K

can be interpreted as a measure of the strength of existing product market competition.

Nonetheless, a low K serves to alter the license fee but does not alter the structure of the

product market.

Several remarks are important at this point. First, policies designed to ensure a

more competitive innovation market (as in Gilbert and Sunshine, 1995), do not necessarily

translate into more product market competition. This is because low entry barriers in

innovation markets, while they might intensify competition there (although this is not

assured), will ultimately generate innovations that will be licensed to existing incumbents.
 23

Second, when the innovation is of no value to the monopolist, i.e., π m (θ ) = π m (θ ) ,

independent innovation will only take place if product market entry is credible, i.e.,

π d > K . But even in this event, the entrant will earn the constrained license fee and the
monopoly will be preserved. Indeed, in this case, any innovative activity that occurs is

strictly welfare reducing. We will return to this point below. Finally, the expected lack of

product market entry as a result of independent innovation draws into question whether

licensing of intellectual property or acquisition of smaller research firms is desirable. While

this possibility helps preserve monopoly, we must first examine its effect on ex ante

innovation incentives before drawing a policy conclusion. We undertake that exercise in

the next section.

I V . Ex Ante Innovation Incentives

We have demonstrated that licensing rather than product market competition is to be

expected when independent research teams generate innovations before incumbents. This

change in expectations has important implications for the question of who is likely to

research more intensively ex ante. This section looks at these incentives beginning first

with a review of analysis of relative innovation incentives when product market competition

is expected and contrasting this with the case when licensing is the appropriate outcome.

Recall that firms have two incentives to research more intensively, willingness to pay and

pre-emption.

The Traditional Model: Product Market Competition Expected

In analyses of technological competition based on Figure One, where product

market competition is the only option, the pre-emption incentive for innovation is greater

for an incumbent than an entrant. Recall that the pre-emption incentive is the difference
 24

between winning and losing an innovation race for a firm. By winning an innovation race,

the incumbent preserves their monopoly profit while by loosing they earn duopoly profits.

Therefore, their pre-emption incentive is: π m (θ ) − π d . Entrants, however, can only hope

to earn duopoly profits by pre-empting incumbents and nothing otherwise. Hence, their

pre-emption incentive, even with zero sunk costs of entry, is at most πd. By assumption 2,

the incumbent’s pre-emption incentive must exceed that of the entrants, so the incumbent

has greater incentives to innovation.

On the other hand, in traditional models of technological competition, the

willingness to pay incentive of incumbents is π m (θ ) − π m (θ ) while that of entrants is

π d − K . If, the innovation did little to enhance monopoly profits, the entrant would have a
greater willingness to pay and possibly a greater overall innovation incentive. For instance,

Reinganum (1983) demonstrated that when an innovation is drastic and cannabilises an

incumbent’s existing assets, the entrant always researches more intensively. This is

because the incumbent’s willingness to pay is close to zero while their pre-emption

incentive is equal to that of the entrants. The incumbent wants to preserve its monopoly

position while the entrant wants to gain precisely that. In general, however, it is difficult to

determine who will research more.

Our Model: Licensing is Expected

When licensing rather than product market competition is expected upon

independent research team innovation, these incentives change dramatically. In particular,

the pre-emption incentives of incumbents and entrants are identical. An entrant can expect

to receive τ if they innovate first and nothing otherwise. The incumbent, on the other

hand, receives π m (θ ) if they are the first to innovate and π m (θ ) − τ if they acquire the

innovation from the entrant. Therefore, its pre-emption incentive is also τ . So while an

entrant’s motivation for winning is to license to the incumbent, the incumbent’s motivation
 25

is to avoid having to license from the entrant. Regardless of the division implied in the

bargaining game, the incumbent and entrant have the same pre-emption incentive.

This fact has an important implication as to how we view pre-emption. For Gilbert

and Newbery (1982), the fact that, when product market competition was expected, the

incumbent’s pre-emption incentive exceeded that of entrants suggested that there might be a

misallocation of resources directed towards research. In particular, an incumbent who was

strictly less efficient in researching than an entrant might nevertheless direct resources

towards this end.6 When licensing is expected, while both incumbents and entrants have a

pre-emption incentive, incumbents cannot rely on differences in this alone to get away with

employing an inefficient research technology. If the incumbent is strictly less efficient in

research than an entrant, this will mean lower the incumbent’s relative incentive to innovate

but will not, as Gilbert and Newbery (1982) suggest cause a stark misallocation of research

resources.7

When licensing is expected, what separates the innovation incentives of incumbents

and entrants lies solely on the willingness to pay side. The incumbent’s willingness to pay

is the same as in the traditional model of technological competition, π m (θ ) − π m (θ ) . The

entrant’s, however, is the license fee it expects to earn, τ . Therefore, if each is equally

efficient at research, the incumbent will research more intensively than the entrant if and

only if π m (θ ) − π m (θ ) ≥ τ . It can be seen immediately from this that if the license fee is

unconstrained by product market competition the license fee is a fraction, α , of the

incumbent’s willingness to pay. Hence, when product market entry is not credible, we

would expected the incumbent to research more intensively than any individual independent

6
Salant (1984) noted that licensing means that an inefficient incumbent would not engage in innovative
activity. Gilbert and Newbery (1984) responded by saying that transactions costs would limit this
possibility. In our framework, which relies on uncertainty, inefficient incumbents will engage in some
innovative activity but less than they would if they were efficient. The pre-emption incentive does not
distort research resources toward the incumbent, however.
7
However, we did identify misallocations due to an incumbent’s incentive to operate an in-house program
in order to appropriate a greater return in the event they negotiation with an entrant. This pathway can give
rise to some of the concerns expressed by Gilbert and Newbery (1982) although the cause is very different.
 26

research team.8 It is only if τ is constrained that it is possible that, π m (θ ) − π m (θ ) < τ and

the entrant has greater innovation incentives. Specifically, for the entrant to research more,

it must be the case that π m (θ ) − π m (θ ) < π d − K .

Table One summarises the above discussion. The point is that, in contrast to

analyses based on product market competition only, with licensing as the expected

outcome, who has more ex ante incentives to research depends solely on willingness to

pay. The pre-emption incentives of incumbents and entrants are identical. Moreover, it is

only when product market competition is credible and affords an entrant sufficient expected

profits, that the license fee they expect will exceed the marginal value of the innovation to a

monopolist incumbent. Only in this case, will the innovation incentives of entrants exceed

that of an incumbent.

Table One: Taxonomy of Innovation Incentives

Willingness to Pay Pre-emption

Expectation Incumbent Entrant Incumbent Entrant

Product Market Competition π m (θ ) − π m (θ ) πd − K π m (θ ) − π d πd − K

Licensing or Acquisition π m (θ ) − π m (θ ) τ τ τ

Accommodation Versus Escalation

The incumbent’s attitude towards independent innovation also changes when

licensing rather than product market competition is expected. Product market competition

turns the innovation race into a tournament. An intensification of research activity on the

part of entrants always motivates a like response from the incumbent. In other words, in

8
In Gans and Stern (1997), we show that when there are multiple entrants, each individually has less
incentive to engage in research than the incumbent. However, as a group they might expend more research
effort overall.
 27

response to competitive pressure from potential entrants, the incumbent escalates their

research activity.

When licensing is expected, the picture can change quite dramatically. If an

independent research team innovates first, the incumbent is not simply left with duopoly

profits but with their monopoly intact and enhanced, for the loss of the license fee. When

this license fee is relatively small, the incumbent may actually derive benefits from

independent researchers engaging more innnovative activity. This is because if an

independent team generated an innovation immediately the incumbent would gain

π m (θ ) − τ rather than their expected value from continuing the innovation race. Therefore,

it is possible that, if τ is unconstrained, the incumbent always prefers entrant innovation to

this possibility. So far from wanting to escalate their own activity in response to

competitive pressure, an incumbent might accommodate that pressure by reducing its own

research effort. Thus, in this case, the incumbent might look upon independent innovation

favourably rather than a threat perhaps to the point of encouraging it by signalling a

willingness to license and engaging in information sharing.

The Replacement Effect

The possibility that incumbents might accommodate entrant innovation alters the

way we look at another phenomenon often discussed in regard to technological

competition, the so-called “replacement effect.” This effect was first analysed by Arrow

(1962), who argued that a product market monopolist would, in our terminology, have a

lower willingness to pay for an innovation than an independent researcher selling to a

competitive market. That researcher could expected to appropriate all the economic returns

from an innovation, while the monopolist while also appropriating those returns would be

concerned about replacing their existing sunk assets. This concern for “cannabilisation” as

it has come to be called would restrict an incumbent’s incentives to innovate.

 28

In our framework, the value of existing incumbent assets is reflected in the pre-

innovation monopoly profits, π m (θ ) . Notice that, if product market entry would

completely cannabilise those assets -- with the incumbent earning neglible profits post-entry

and the entrant earning π m (θ ) -- the entrant’s willingness to pay if π m (θ ) exceeded K

would be greater than the incumbent’s. Thus, akin to the results of Reinganum (1983), an

entrant might have greater ex ante innovation incentives than the incumbent.

However, this situation relies critically on two assumptions. First, product market

entry by independent researchers must be credible. Second, intellectual property rights

must be strong. Relaxing either of these assumptions might swing incentives in the

incumbent’s favour. But more critically, as the value of existing assets rises π m (θ ) can we

indeed say that the relative incentives of the incumbent as opposed to the entrant

diminishes?

The answer is no. Increasing π m (θ ) reduces the incumbent’s willingness to pay

for an innovation but it also has an effect on the license fee. Greater pre-innovation profits

makes the incumbent more patient in bargaining as it is able to earn these profits during

negotiations. Moreover, a higher π m (θ ) reduces the value of the innovation to the

incumbent. Since entrants without product market alternatives can only appropriate a share

of this value, their returns are, in turn, reduced. So as π m (θ ) rises, τ falls and hence, the

incentives for entrants to engage in research are diminished for both their willingness to pay

and pre-emption incentives are lower.

For the incumbent, the effect of a change in π m (θ ) is ambiguous. While, in

traditional models, this led to a decrease in research effort, this only occurs now when the

license fee is high so that incumbents decide to reduce their own activity as a strategic

response to the reduction by the entrant. When the license fee is low (or unconstrained) the

incumbent wants to accommodate entrant research. Hence, when independent research

falls in response to a rise in π m (θ ) , the incumbent decides to raise its own research profile
 29

in an attempt to elicit a competitive strategic response from entrants. Thus, it is possible

that the replacement effect could be positive with greater cannabilisation eliciting more

intense research on the part of incumbents.

V. The Welfare Implications of Licensing and Acquisition

We have demonstrated above that the possibility of licensing or acquisition means

that one would expect that independent innovation would not result in increased product

market competition. Moreover, this possibility alters the incentives and strategic

relationship between incumbents and entrants. A natural question to ask, therefore, is:

should licensing or acquisition be permitted?

By not permitting cooperative arrangements, it is possible that innovation by

independent teams could lead to forward integration by them into product markets, thereby

reducing the market power of incumbents. For this to occur, however, that entry must be

credible. As such, in analysing the welfare implications of licensing and acquisition it is

important to distinguish between the cases of credible versus non-credible entry.

When entry is not credible (i.e., π d < K ) not permitting licensing or acquisition

removes the outlet by which independent research teams can earn an economic value on

their innovations. Hence, all innovation would be in the hands of incumbents. As

incumbents would accommodate entrant innovation when entry is not credible, the removal

of independent innovation incentives might raise incumbent innovation. Theoretically, this

means that overall innovation could be enhanced when licensing is not permitted but if

incumbents are for some reason less efficient than entrants at research, this theoretical

possibility is unlikely to hold in reality. This is especially true if there are many potential

entrants into the innovation market.

When entry is credible, it is possible that by banning licensing or acquisition,

innovation on the part of entrants could make product markets more competitive.
 30

However, the removal of the licensing option has a first order negative effect on entrants ex

ante innovation incentives. They earn τ rather than π d − K in the event they innovate. The

license fee must always exceed or equal π d − K , hence, given that greater research effort

on the part of incumbents puts pressure on entrants to do more, banning licensing will

reduce their equilibrium research incentives. For incumbents, when entry is credible,

license fees are likely to be relatively high. Thus, a decrease in the intensity of entrant

research could diminish their own research effort. So even in the credible entry case,

restrictions or regulatory uncertainty regarding licensing can cause a reduction in overall

research effort. Moreover, if entrants are more competent at innovation than incumbents

such policies would distort the optimal allocation of research effort.

If an innovation has no economic value to the incumbent, i.e., π m (θ ) = π m (θ ) ,

licensing or acquisition is not desirable from a welfare point of view. In this situation,

innovative activity will only occur if entry is credible. In this case, the incumbent will be

motivated to undertake ex ante innovative activity solely for the purpose of pre-empting the

entrant. But regardless of who innovates first, for consumers the result will be the same, a

continuued monopoly. By placing restrictions on licensing of such innovations, research

activity takes place but at a diminished rate. However, if the entrant innovates first there is

at least some benefit to consumers. Note, though, that incumbents have a greater pre-

emption incentive in this event and hence, they could innovate more intensely than entrants.

Hence, restrictions on licensing, while yielding a potential gain to consumers could cause a

greater level of wasteful research activity.

As a final consideration, it is argued that, in the spirit of the “replacement effect”

that licensing creates incumbency rents and hence, might reduce future innovative activity.

Our analysis of the previous section casts doubt on this presumption. When licensing is

permitted that replacement effect serves to diminish entrant research while the effect on

incumbents is ambiguous. The effect on overall innovation is, therefore, uncertain and

hence, it cannot be concluded that licensing will reduce rates of future innovation.
 31

We, therefore, argue that while restrictions on licensing or vertical acquisitions can

allow the possibility that innovative activity could lead to increasing competitiveness this is

not a given. Moreover, such restrictions are likely to have overall negative effects on the

total level of innovative activity. Finally, given the ambiguous relationship between

cannabilisation and innovation incentives, it is not clear that allowing licensing will reduce

future innovation incentives.

VI. A Final Caveat: Information Asymmetries and

Transactions Costs

The Coasian feel of our analysis suggests some qualification is in order. When

there are information asymmetries between two parties at a negotiation, there is a possibility

that the bargaining process might breakdown to their mutual detriment. Such transactions

costs restrain the ability of two parties to reach joint profit maximising agreements. In this

case, bargaining breakdown could lead to product market entry, although the expectation of

such transactions costs will have the same effect on incentives as regulatory uncertainty

over licensing possibilities.

There are reasons to suppose that contractual arrangements over innovation will be

surrounded by information asymmetries. For example, an independent research team

might believe that the economic value of its innovation is high relative to what an incumbent

believes that innovation’s value is. In this case, in negotiations, the entrant will overstate

their demands while the incumbent will understate theirs. Thus, there is a possibility that

negotiations could break down without any licensing agreement being reached.

Another possibility, noted by Arrow (1962), is that when property rights are weak,

crucial information may be revealed by the bargaining process itself. By this we do not

mean reverse engineering. That is information revealed by product market entry. What we

mean is the revelation of technical knowledge that adds to the incumbent’s research

competency increasing the possibility that it could itself generate a substitute innovation. In
 32

this event, independent researchers might fear expropriation by even beginning negotiations

with incumbents and instead, to their mutual detriment, choose to enter into product market

competition.

From a policy point of view, such transactions costs are a welfare loss. They result

in more potential product market competition but when such entry is not credible, they can

reduce overall innovation levels. Thus, while transactions costs can lead us to understand

when successful product market entry is sometimes observed, such observations are not

necessarily indicative of efficient market processes but rather bargaining failures.

 33

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