My Presentation - Lecture Slide R&D Patent Licensing

Uday Bhanu Sinha Delhi School of Economics
Economics of Innovation, IPRs and Technology

Transfer
Uday Bhanu Sinha
Delhi School of Economics
Innovation is at the heart of economic growth and development.
Product innovation: is a new or improved good or service.

Process innovation: lowers the cost of producing an existing good or service.
1. Innovation and market structure :

Which market structure is good for innovation:
monopoly or perfect competition or oligopoly?
Competition and Innovation debate: What’s the relation?
Schumpeterian (1942) view: monopoly has the highest incentive for

innovation.
Schumpeter
 capitalism as developing through gales of ‘creative destruction’. The
creative destruction is a process whereby old ideas and industrial
structures (products, processes and organizations) are continually
replaced by new industrial activity. This is the source of continuous
progress and improved living standards.
1
 continual R&D leads to periodic waves of new technology that in turn

lead to sweeping changes in the product- market positions of suppliers.
 for purposes of promoting economic welfare, “perfect competition is
not only impossible but inferior, and has no title to being set up as the
model of economic efficiency.”
Monopoly may be better:

1) R&D is very costly. Large firms might be better able than small
ones to fund large R&D projects.
2) They can recoup the cost as they supply large amount of outputs.
3) There is no threat of rival imitating the technology.
When the returns to an innovation is more for a firm that first develops the
idea, the greater is the incentive for the firm to engage in R&D activity.
Schumpeter’s argument is that most technological innovation would come

from large corporations with market power and organized R&D operations.
In competitive market: each firm is small having little resources, and there is
threat of imitation from the rival firms.
However, as John Hicks (1935) famously remarked,

“[the] best of all monopoly profits is a quiet life.”
Arrow (1962) challenged the Schumpeterian view.
2
Arrow’s view:
 a firm operating under perfect competition would have the highest
possible incentive to strive for an innovation. This is because, if
successful, the firm can throw its rival out of the market and acquire
monopoly position.
 a pre-innovation monopolist has a weaker incentive to innovate than a

firm operating in a competitive market: due to “replacement effect”,
and organizational inertia.
 when there is competition to innovate, monopolists innovate at a

slower rate than competitive firms, who in turn innovate below the
social optimum level.
The opposite view: competition will drive organizations to be more innovative

than a protected monopoly position.
Reasons: 1) Business stealing effect: there is the possibility of using

innovation to steal business from rivals.
2) Preemption effect: In a race to obtain a patent, preempting rivals by a day
can mean the difference between obtaining valuable intellectual property
rights for a firm or seeing the gains go to a competitor. Thus, firms may have
sizable incentive to invest in R&D in order to innovate quickly.
3) Licensing opportunity: Strong intellectual property rights can reduce
some of the risks associated with the imitation by rivals. And licensing may
3
make it possible and profitable to diffuse an innovation throughout an industry

with many firms.
4) R&D Race effect: In a competitive market, more firms are searching for
innovations, therefore, the probability of an innovation being discovered in
any time period is high.
Monopoly and the presence of entry barriers may then lead to inefficiencies
in innovation.
In short, a firm facing strong product- market rivalry has an incentive to

develop new products and processes that will help it improve or defend its
market position.
4
A formal analysis:
Price
Demand
c0 b
c1 d
q(c0) q(c1) Quantity
Social optimum:
Assume that the innovation is available for use under perfect competition
and the public pays for the R&D cost with no dead weight cost to the society.
Suppose a homogeneous good is sold at a price p and produced at a constant
marginal cost, c.
Assume a linear demand function: q (p).
Social welfare = consumer surplus + producer surplus
Market price in equilibrium : p = c.
Suppose from an R&D investment the marginal cost goes down to c1< c0.
As a result, the change in social welfare is the area c1c0bd in figure.
5
Monopoly production:
A process innovation is drastic if the monopoly price with the innovation is
lower than the marginal cost before the innovation: pm(c1) < c0. The new
technology makes the old technology obsolete.
If the opposite happens (pm(c1) ≥ c0) then the process innovation is known to
be non-drastic.
Price
Pm(c0) Demand
c0
pm(c1)
πm(c1)
c1
qm(c0) qm(c1) Quantity
Monopoly profit with drastic innovation
6
Price
Pm(c0) Demand
pm(c0)
pm(c1) πm(c0)
c0
πm(c1)
c1
qm(c0) qm(c1) Quantity

Monopoly profit with non-drastic innovation
The change in monopoly profits from the cost reduction is ∆πm = πm(c1) –
πm(c0).
By comparing the social and monopoly incentive for cost reduction we find
∆W > ∆πm
The monopoly value of a process innovation is less than the social value.
Innovation replaces the monopolist’s old profit stream πm(c0) with a new profit
stream πm(c1). This is known as replacement effect.
This effect reduces the incentive of the monopolist to invest in R&D.
There is a replacement effect for the society as well.
The difference in the value of R&D stems from the differences in the output
levels between socially optimal and monopoly outputs.
7
Competition:
Assume that the innovator has an exclusive intellectual property rights.
There is perfect competition with the old technology. All firms are earning
zero profits.
The successful innovator’s profit from innovation is the monopoly profit
πm(c1) under drastic innovation.
Hence,
∆πC = πm (c1) > ∆πm
Thus, the incentive to invest in R&D is higher under perfect competition than
monopoly as there is no “replacement effect”.
Note that ∆πC = πm (c1) < ∆W for drastic innovation
For non-drastic innovation
The innovator would charge the price marginally less than c0 >p and earn a
profit.
So, ∆πC = (c1 – c0)q(c0) < ∆W
Thus,
Social incentive > competitive incentive > monopoly incentive for R&D.
In the theoretical models, excessive innovation may arise when the innovator
profits mainly by stealing business from its rivals, rather than by expanding
the market.
8
The debate sparked an extensive economics literature on innovation and

competition.
Some general observations on the debate:
First: competition in innovation itself encourages innovation.

When firms see themselves in a tough race to innovate first, they try harder
to win. This dynamic effect is particularly evident in the literature on “patent
races.”
Second: competition among rivals producing an existing product encourages

those firms to find ways to lower costs, improve quality, or develop better
products.
Firms engage in research and development because innovation may allow
them to escape competition, and so earn greater profits.
Third: firms that expect to face more product market competition after
innovation have less incentive to invest in R&D.
Fourth: preemption incentive: a firm will have an extra incentive to innovate

if in doing so it can discourage potential rivals from investing in R&D.
9
Characteristics of innovation under monopoly

Patent Shelving under monopoly: monopolist may want to obtain property
rights on an innovation even though he will not make use of it. This may occur
for a production technology which is not very superior or for a product
innovation which is not very differentiated from the monopolist’s product.
The purpose is to prevent entrants from competing.
In reality, many innovations are made by firms with dominant market share
such as Microsoft Corporation.
Entry barrier: When barriers to entry are low or non-existent, monopolists

usually try to innovate rapidly to retain their market share and high profits.
If the barriers to entry are high, the incumbent will have no immediate
need to invest in new technologies as its existing monopoly is less likely to
be challenged. However, with the possibility of leapfrogging, small potential
entrants are capable of “leapfrogging” the incumbents to gain a larger
proportion of the market.
Because of this, theory suggests that monopolists always have incentives to

innovate whether barriers to entry are high or low.
Patent Race:
First, the incumbent earns profits while working on the innovation, while the
entrant does not. It can be shown that in the case of drastic innovations, this
replacement or ‘Arrow’ effect prevents the incumbent from winning the
race.
10
Which assumption is more appropriate, leapfrogging or step-by-step

innovation?
Will innovation lead to persistent monopoly?
Sometimes the current laggard wins the next race if there is leapfrogging.
The innovative success of the current laggard does not catapult into the
technological lead, but merely closes the gap between the firms. This allows
for firms competing neck-and-neck.
As such, no easy and clearcut answer can be given to the question whether
a technological monopoly will persist.
Inverted U curve:
Imperfect market structure with strategic rivalry is the right market
structure for innovation.
An early and influential study by F. M. Scherer (1967) found that the
relationship between market structure and innovation to follow an
inverted-U pattern.
Schmidt (1997) and Aghion et al. (1999) : competition makes bankruptcy

more likely.
11
Schmidt (1997) : greater competition has two effects:

1) Greater competition increases the risk of bankruptcy, and thus
competition results in more innovative effort.
2) Competition also lowers the return to a cost-reducing innovation by
reducing the output of each firm. They act in different directions.
Thus, Schmidt’s model can generate a relationship between innovation and
competition that has an “inverted-U” shape.
2. R&D Race and Organization:

(Oz Shy)
The timing of innovation plays a crucial role in the market place.
A firm that is first to discover gain an advantage over competing firm.

Reasons:
First, the firm is eligible to obtain a patent.
Second, consumer will be willing to pay high if it is a higher quality product.
An example
Suppose two firms searching for a new technology. The discovery is
uncertain. Suppose the discovery translates into a prize.
The required R&D investment of a firm is I (fixed).
There is a probability α of discovering the technology.
If the firm is a sole discoverer then the value is V and if both firms discover
V
then the value is each.
2
12
If the firm fails then 0 is the return.
Suppose, both firms undertake R&D then

V
Expected profit for each firm, Eπ = α(1 – α)V + α2 –I.
2
Both firms will undertake R&D if Eπ ≥ 0
 (2   )V
I
2
More number of firms means duplication of R&D investment, which may

not be good for the society.
Social surplus if both firms undertake R&D is
2α(1 – α)V + α2V – 2I
= α(2 – α)V – 2I
If one firm undertakes R&D then expected profit αV – I = social surplus.

Social optimum: one firm undertaking R&D is socially optimal
if α(1 – α)V<I
13
Private
Both do R&D One does
Both One I
 (2   )V
Social α(1 – α)V αV
2
 (2   )V
When α(1 – α)V<I< , it is a case of market failure.
2
R&D cooperation can solve this problem.
R&D Organization: (Marjit 1991)

Suppose two firms can cooperate.
They share the cost of R&D and share the value half each if the R&D is
successful.
By cooperating each firm will receive
V I
α 
2 2
From undertaking R&D separately each firm will receive
 (2   )V
I
2
Firms would prefer to cooperate provided
I > α(1 – α)V.
14
α(1 – α)V
I
0 α1 non-cooperative α2 1 α
Cooperation is preferred for both higher and lower values of α.
Intuition:
R&D cooperation and spillover:

Oz Shy example and results.
Spillover : When some discoveries are made public during the innovation
process (i.e., secrets not kept) or the labs investing in infrastructures or
research institutes that benefit all other firms.
A duopoly example with spillover:
Suppose the inverse demand function is p = 100 – Q.
Consider a two stage game:
15
First Stage: R&D stage: firms decide how much to invest in cost reducing
R&D.
Second Stage: Cournot competition.
Assume that xi is the amount of cost reduction for i th firm and the cost of
2
xi
such R&D is: TCi = .
2
The unit production cost is
ci = 50 – xi – βxj i≠j and i = 1, 2; β≥0.
β measures the spillover effect.
Noncooperative R&D:
Choose R&D level first and then choose level of outputs in the second stage.
Second Stage :
(100  2ci  c j ) 2
Profit πi =
9
(100  2ci  c j ) 2 2
xi
First stage: Max – .
9 2
50(2   )
FOC yields x NC 
4.5  (2   )(1   )
Cooperative R&D :
First stage they jointly choose R&D levels to maximize their joint profit.
Second stage: They compete in the market place.
Assuming symmetric equilibrium: the firms R&D levels would be
50(   1)
x iC = x jC =
4.5  (   1) 2
Results:
1. Cooperation in R&D increases firms’ profits.
2. If β> ½ , then xC > xNC and QC>QNC.
16
3. If β< ½ , then xC < xNC and QC<QNC
Intuition: Under Cooperation they would choose R&D investment to

maximize joint profit from R&D, i.e., they internalize the effect of
externality. As a result, for greater spillover level, cooperation generates
higher R&D expenditure, outputs and welfare .
For low spillover, non-cooperation is better as the R&D intensifies the cost
advantage of the firm that undertakes higher level of R&D.
Since R&D cooperation is privately profitable, so no reason to provide

government incentives beyond allowing competing firms to engage in
cooperative R&D projects.
An oligopoly with n firms without spillover (Motta, 2004).
Results: R&D level choice depends on three effects:

Market size effect: the larger market demand the stronger the incentive to
do R&D.
Competition effect: as the number of firm increases the R&D incentive also
increases at a decreasing rate and then starts falling with number of
firms.
Cost of R&D: the larger is the cost less is the R&D.
More number of firms in the industry the larger is the total amount of R&D
but this duplication of costs reduces the overall producer surplus and as a
result a welfare loss.
17
Incentives for cooperative R&D:

1) Spillover
2) Uncertainty in R&D process
3) R&D cost sharing
4) Pooling complementary research skills or knowledge to develop a new
technology.
Other forms of cooperation: Cross licensing and patent pooling
Cross licensing occurs when two firms reciprocally allow each other to use
technology protected by patents.
Competition effect: This may reduce the competition in the market place
when technologies are substitutable and licensing is done through royalty.
Complementary effect: However, when firms have essential (blocking)
patents that are needed for further technological progress or final production.
Cross licensing may allow the use of complementary technology leading
to technological advance.
Patent pool: suppose a firm or organization that holds the patent rights of two
or more firms and licenses them to third parties as package. If the patents are
complementary then it is highly desirable.
Studies also show that the social return to investment in R&D is higher
than the private return.
18
3. Patenting
Patent is the legal right granted by the government to an innovator to exploit
a particular invention for a given number of years. It gives temporary
monopoly right to the firm.
Thus, the patent gives its owner the right to exclude others from making,
using, or selling any product embodying the patent. This right also allows
the patentee to license the patent.
According to US constitution, intellectual property rights are granted in order

to “promote the Progress of Science and useful Arts”.
The prominent approach to the economic analysis of patent draws from the
classic work of Nordhaus (1969) and assumes that unpatented innovations
are easily imitated and thus focuses on “non-exclusive” nature of
technological knowledge.
By this theory, in the absence of Patent system there would be too little
investment in R&D.
There is a general agreement that patent system is useful for encouraging

new product development and process innovation despite the market
distortion it creates (static inefficiency of monopoly) .
Two goals of patents:

1) To provide the incentives for producing know how.
2) To make the new information available to the public as fast as possible.
19
The second goal of publishing information reduces extra cost of duplication

by another firm.
Different kinds of patents: Product patent, process patent, design patent etc.
For patenting an invention must be novel, non-trivial and useful.

It should not infringe on earlier patented innovations.
Two theories of patent: Reward theory and contract theory.
According to reward theory of patents, the function of a patent system is to
reward the innovator so as to encourage the R&D effort.
When the innovations can be concealed the patent system can be viewed as
a “contract” between the society and the innovators whereby a temporary
property right is granted in exchange of disclosure.
Patent plays a minor role in encouraging innovation in some industries such

as computers, information and communication technologies and software.
The empirical evidence shows that the incentive effect of patent is very
small or negligible and that the firms would have a substantial incentive to
innovate even in the absence of intellectual property rights.
20
Patent vs. trade secret
Also secrecy or lead time provide a reward to innovators when they are a
source of market power.
Both lead time and secrecy mean that the mere fact the innovator practices
the innovation may not disclose enough information to allow instant and
costless replication by others.
Empirical findings in a survey of US firms suggest that both lead time and
trade secrecy are considered more effective mechanism than the patent
(Cohen et al.(2000)).
When the innovators have the option of secrecy, Boldrin and Levine (2004)
argued that those innovations will be patented where secrecy cannot keep
it for that long. Thus, patent system means protecting too long.
However, secrecy does not preclude either the inadvertent disclosure or the
independent creation by others. Under trade secrecy duplicative R&D for
independent rediscovery is largely wasteful and the evolution of market
structure is also different under trade secrecy.
21
Optimal patent length Issues:

Duration of the patent:
In US it is 17 years and in Europe around 20 years.
Suppose an investment in R&D reduces the unit cost of production from c>0
x2
to c – x . The cost of undertaking the R&D level x is . Assume a minor
2
innovation.
Demand p = a – Q
Price
Cs0 Demand
c b
M DL
c-x d
a-c a-c-x Quantity
Innovator enjoys the monopoly profit M for T periods and 0 profits from
T+1 onwards.
DL : the deadweight loss for the society.
After T periods all firms have access to the new technology and the
market becomes competitive again.
δ: discount factor.
The innovators profit in T periods
22
1  T
M +δM + δ2M + … + δT-1M = M
1
The innovator maximizes profit by choosing x
1  T x2 1  T x2
Max M - = Max (a – c)x - .
1 2 1 2
1  T
Hence the optimal choice x = (a – c)
1
Results:
1. The R&D level increases with the duration of the patent.
2. The R&D level increases with an increase in demand and decreases
with an increase in the unit cost.
3. The R&D level increases with an increase in the discount factor δ.
Society’s optimal duration of patent:

Government legislates the duration of the patent to maximize social welfare
taking into account how the duration of patent affects the innovator’s R&D
level.
During patent period society’s welfare is CS0+M and after patent expiry
CS0+M+DL.
Result: The optimal patent length is finite.
23
Patent enforcement in the context of North-South technology

transfer:
Licensing and IPRs (Sinha, 2006)
The issue of patent protection is one of the most contentious issues.
In a North-South framework, consider a two period model.

An MNE possesses a technology (call it technology 1).
There is patent protection in the North.
We assume that the MNE can innovate a new technology.
However, the outcome of this process innovation is uncertain.
The Northern firm would be successful in innovation with probability p and
1
the related R&D expenditure is Kp 2 where K is a positive constant.
2
This new technology (call it technology 2), if available, will be used only for
the second period’s production and technology 2 is ‘drastic’.
Two modes of operation for the MNE: licensing and subsidiary.
The Game:
First period: The Northern firm may either set up a subsidiary on its own or
make an offer to license out technology 1 to a Southern firm.
Second period:
24
The second period licensing game.
Northern firm
Renew licence
Southern firm
Accept Reject
Northern firm
Enter Not
The technology transfer under licensing facilitates imitation.

For a wholly owned subsidiary the Northern firm has to incur a setup cost F
>0 but avoids imitation possibility.
Under subsidiary operation the MNE expects to receive from its R&D
1
p(2) + (1-p)1 – Kp 2 ;
2
The Northern firm choose pS.

The first order condition implies
( 2   1 )
pS = , which is positive.
K
The Northern firm’s total two period’s payoff under the subsidiary operation
is:
1 2
RS =1- F + pS(2) + (1-pS)1 – Kp S
2
25
Licensing:
Assume that the patent enforcement in the host country is imperfect.
Imitation is costless.
There is a positive probability,  , that the local court in the South, in the
beginning of the second period, will be able to detect the imitation and
debar the Southern firm from using it in the second period (where 0    1 ).
On the other hand, if the imitation is not detected by the Southern court, the
Southern firm will be able to use the first period technology in the second
period. This happens with probability ( 1   ).
Under the licensing contract in the first period, the Northern firm expects to
get by investing in R&D under the partial patent enforcement
1
p(2) + (1-p) {  1 +( 1   )(1 - 1d)} – Kp 2 .
2
Thus, the choice of p under licensing (L).

( 2  1 )  (1   )1d
p 
L
K
The Northern firm receives the total payoff under the licensing contract,
1
RL( )=1 + pL(2) + (1-pL) (1 ) –
2
Kp L .
2
Result:
The innovation rate is higher under the licensing contract with imperfect
patent enforcement (i.e., 0<<1) than under the subsidiary operation. Also,
the lower is the degree of patent enforcement in the South, the higher is the
innovation rate in the North under licensing contract.
The welfare in South is only dependent on consumer surplus.
26
The consumer surplus depends on the probability of introducing the better

technology in the South.
Therefore, the consumer surplus varies inversely with the degree of patent
enforcement.
By comparing payoffs from Licensing and Subsidiary,
RL(), RS
RS at small F
RS at large F
0 * 1 
For large enough F, the optimal degree of patent enforcement  = 0.

For smaller F, the optimal degree of patent enforcement is *.
Result:
For large F, the optimal degree of patent enforcement for the South is zero.
However, for smaller F, the optimal degree of patent enforcement is positive
and given by  *.
27
Parallel Trade
Parallel imports are legitimate goods brought into a country without the
authorization of the patent, copyright or trademark owner, once the goods
have been sold in another country.
Article 6 of agreement on Trade Related Aspects of Intellectual property
rights (TRIPS) in the Uruguay round allows countries to decide on their
parallel imports policies.
The policy regarding parallel imports depend on the specification of territorial
exhaustion of intellectual property rights (IPRs).
Under national exhaustion, rights are exhausted upon first sale within a
country but IPR owners may prevent parallel imports from abroad (e.g., the
United States follow this policy).
Under the doctrine of international exhaustion, rights are exhausted
internationally upon sales and as a result parallel imports cannot be prohibited
(followed by Australia, India New Zealand, the United Kingdom and Japan).
There exists an intermediate exhaustion pursued by EU, in which the rights
are exhausted within a group of countries and thus permitting parallel
importing among them but not from outside the region.
Patents provide inventors of new products and technologies the legal right to
exclude rivals from making, selling, and distributing those inventions.
Trademarks provide their owners the right to prevent rivals from using
identical or confusingly similar identifying marks and trade names on their
goods.
There are many instances of parallel imports, for example, imports of Levi’s
Jeans to the UK by Tesco, a British supermarket chain. Tesco deliberately
28
buys Levi’s jeans from outside the EU without getting permission from the
manufacturer and sells them in the UK at lower prices than the prevailing
prices.
In the UK parallel importers have their own association, so-called Parallel

Traders Association (PTA) that lobbies governmental authorities on behalf of
themselves.
In 1997, South African government passed a legislation that sets up a system
to permit parallel importation of medicines in order to make the access to
medicines more affordable to people. However, the US and the EU put a lot
of pressure on the South African government to rectify the legislation. This
eventually led to a softer stance from the South African government.
Pharmaceutical products, for example, generally begin life with patent

protection in one or more countries. New machinery and transport equipment
embody numerous technologies in their component parts that may also be
patented. Digital products, such as music recordings on compact
disks and software, are sold under copyrights. New cinematic films and
television broadcasts similarly have exclusive rights under copyright
protection. Fashion goods and cosmetics are marketed in different countries
with the benefit of trademarks, brand names and logos. Indeed, many products
incorporate a complex mix of numerous IPR.
Medicines, for example, may be patented but are sold by licensed companies
bearing the rights to use registered brand names and trademarks. Microsoft’s
software products embody patents, copyrights and brand names.
29
TABLE 1
Summary of IPR Exhaustion Regimes
Sources: National Economic Research Associates (1999) and International Intellectual Property Alliance (1998).
Country Trademarks Patents Copyrights

European Union Community Community Community
Exhaustion Exhaustion Exhaustion
USA National National National
Exhaustion Exhaustion Exhaustion
Japan International Same as trademarks International
exhaustion unless exhaustion except
agreed by contract for motion pictures
or original sale is
price-controlled
Australia International National exhaustion National exhaustion
Exhaustion unless sold by except for compact
patent owner discs and books
without clear
restrictions
India International International National
exhaustion with
exhaustion exhaustion
exceptions
30
4. Licensing of technology
Innovator may be an Outsider or an insider.
For outsider this is the only way to exploit the innovation.
For insider patentee this provides additional source of revenue.
Licensing takes place in different forms: auction, fixed fee, royalty fee and
a two part tariff.
Royalty is distortionary as it increases the effective marginal cost of the
licensee or user.
In an R&D race, licensing increases both the reward for acquiring the
innovation and reward for loosing the patent race.
The exact incentive to undertake the R&D depends on how much of the
common surplus the licensor can appropriate in the licensing arrangement.
Licensing of technology may discourage future R&D by the licensee.
The results for optimal licensing policies are:

Standard Literature:
For an outsider patentee: an upfront fixed fee licensing (or auctioning a
certain number of licenses) is optimal.
(see Kamien and Tauman (1986), Katz and Shapiro (1986), Kamien, et. al.
(1992), Kamien (1992) (see Sen (2005) for exception));
For insider patentee: a royalty licensing is optimal.

(see Rockett (1990), Marjit (1990) and Wang (1998)).
Sen and Tauman (2007) considered optimal licensing for Cournot oligopoly
for both insider and outsider patentee. They found that optimal combination
31
of upfront payment and royalty can lead to licensing to almost all firms in case
of non drastic technology. For drastic technology only one firm would be
licensed or a set of firms so that monopoly profit is obtained by the innovator.
For n firms oligopoly
The willingness to pay for the license is higher under auction than fixed fee.
Innovator announces to sell k licenses under auction then willingness to pay
would be πL (k) – πN(k).
For fixed fee the innovator announces the fee at which any firm willing to
buy can do so. A deviant firm reduces the number of licenses sold by simply
not buying. Thus for any k any firm’s willingness to pay is πL (k) – πN(k-1),
which is lower compared to auction.
Sen and Tauman (2007) proposed auction plus royalty (AR) policy.
The innovator first announces the royalty then auction off one or more licenses
possibly with a minimum bid.
Payment to the innovator : b+ rq = b + (ε-δ)q where δ = ε-r = the effective
marginal cost savi9ng from the innovation.
b = πL(k, δ) – πN(k, δ) when at most n-1 license is offered.
For n firm licensee
b = πL(n, δ) – πN(n-1, δ) ( the minimum bid is stipulated in the auction)
Result: Drastic innovation is licensed to only one firm.
k-drastic innovation: k is the minimum no. of firms such that if k firms have
the licenses then all other firms drop out of the market and a k firm natural
oligopoly is created.
Result: For non drastic innovation (with two firms + innovator) at least
n-1 firms are licensed.
Stamatopoulos and Tauman (2009): Fixed fee is better than auction with
asymmetric firms. The idea of patent shelving is used for this result.
32
Sen and Stamatopoulos (2009): There exists multiple optima for drastic
innovation.
(Poddar and Sinha, 2010), Economic Record.

Licensing in a duopoly
Two types of patentees: the outsider patentee and the insider

patentee.
Technology licensing studied: where the competing firms

are symmetric in terms of cost of production in the pre-
innovation stage or when the patentee is more cost efficient
compared to the licensee.
Our contribution: when the technology transfer takes place

from a relatively cost inefficient firm to its efficient
counterpart.
In standard licensing literature technological efficiency is

not distinguished from cost efficiency.
Our major point of departure from the existing literature is

the initial costs asymmetry in the pre-innovation stage.
The Basic Framework
Consider a Cournot duopoly model with firms producing a

homogenous product.
33
The inverse demand function is given by p  a  Q.
Initially firms are asymmetric.

Firm 1, the innovative firm, has marginal cost of production
c1 and firm 2 has c2 .
We assume:
(i) c1  c 2 .
(ii) Both firms are active and producing positive quantities.
This implies ( a  2c1  c 2  0 ).
(iii) Firm 1 comes up with a cost reducing innovation.
After innovation its marginal cost becomes c1   , where
 ( 0) is the amount of cost reduction.
Depending on size of  the innovation can be drastic or non-
drastic.
No Licensing
When firm 1 and firm 2 compete with costs c1   and c2

respectively, then Nash equilibrium quantities are:
a  2c1  c 2  2 a  2c 2  c1  
q1  and q 2  .
3 3
34
Profits under drastic innovation are:

a  c1   2
 1NL  and  2NL  0 (1)
4
Profits of firms under non-drastic innovation are:
a  2c1  c 2  2 2
 1NL  and
9
a  2c 2  c1   2
 2NL  (2)
9
Licensing Game
First stage: The firm 1 decides whether to license out the

technology.
Second stage: The firm 2 decides whether to accept or reject
the offer.
Third stage: Both firms compete as Cournot duopolists.
Non-Drastic Innovation ( 0    a  2c 2  c1 )
Consider the general licensing scheme ( f , r ) . Both
f , r  0 and r   .
Suppose the firm 2 accepts the licensing contract ( f ,r ).

The firm 2’s profit would be
a  2c 2 c 1   2r 2
 f.
9
35
In case the firm 2 does not accept the licensing contract, it

receives a payoff
a  2c 2 c 1  2
.
9
Thus, for any r, the firm 2 would accept the licensing
contract if the fixed fee is not greater than
a  2c 2 c 1   2r 2 a  2c 2 c 1  2
f   .
9 9
Thus, the firm 1’s total payoff is
a  2c1  c 2    r 2
 1f  r  
9
a  2c 2 c 1   2r 2 a  2c 2 c 1  2

9 9
 a  2c 2    2r  c1 
+ r  (3)
 3 
The unconstrained maximization with respect to r of the
above payoff function yields
a  5c1  4c 2  
r . (4)
2
Now depending on the parameter configuration we have
three distinct possibilities.
36
f *  0 , r*   . f *, r*  0 f *  0, r*  0
C1
a  4c2   a  4c 2   a  c2
c2
5 5 2
Figure 1
Result
Under non-drastic innovation, the optimal licensing policy is
as given below.
a  4c 2  
(i) for c1  , only fixed fee is charged.
5
a  4c 2   a  4c 2  
(ii) for  c1  , two part tariff is
5 5
charged.
a  4c 2  
(iii) for  c1 , only royalty is charged.
5
Drastic Innovation (   a  2c2  c1 )
Result:
Under drastic innovation, the optimal licensing policy is
always a two-part tariff licensing scheme.
37
Intuition: There are two effects of licensing the innovation.

First effect is the overall efficiency gain in the industry and
the second effect is the increase in the competition
between two firms.
The paper provides a platform to bridge the literature on

outsider and insider patentees.
Wang 1998
When firm 1 and firm 2 compete with costs 𝑐 𝜀 and c

respectively, then Nash equilibrium quantities are:
Profits under drastic innovation are:
and  2  0
NL
𝜋 (1)
Profits of firms under non-drastic innovation are:
𝑎 2𝑐 2𝜀 𝑐
𝜋
9
𝑎 2𝑐 𝑐 𝜀
𝜋
9
(2)
38
Licensing Game
First stage: The firm 1 decides whether to license out the

technology.
Second stage: The firm 2 decides whether to accept or reject
the offer.
Third stage: Both firms compete as Cournot duopolists.
Non-Drastic Innovation ( 0 𝜀 𝑎 𝑐)
Drastic Technology (𝜀 𝑎 𝑐)
Fixed fee licensing
F=𝜋 𝜋 =
Firm 1’s total payoff 𝜋 𝐹
Firm 1 would be willing to license under fixed fee
if 𝜋 𝐹 𝜋
This implies 𝜀 .
So license if 𝜀 ,
No license if 𝜀 .
Under royalty licensing

0 𝑟 𝜀
Suppose the firm 2 accepts the licensing contract.
Firm 1’s profit
𝑎 2𝑐 2𝜀 𝑐 𝜀 𝑟 𝑎 𝑐 𝜀 𝑟
𝜋
9 9
39
The firm 2’s profit would be

𝑎 2𝑐 2𝜀 2𝑟 𝑐 𝜀 𝑎 𝑐 𝜀 2𝑟
𝜋
9 9
Firm 1 maximises its total payoff with respect to r
𝑟
The unconstrained maximization with respect to r of the
above payoff function yields
𝑟 . (4)
Note that 𝑟 𝜀. By imposing natural restriction of 𝑟 𝜀 we

find that the optimal royalty would be 𝑟 ∗ 𝜀
Now check that firm 1 would always license the technology
under royalty contract and receives
𝜀 >𝜋
Now comparing the payoff under royalty licensing and fixed

fee licensing we find that
𝜀 >
If 0.
This holds.
40
Under drastic technology firm 1 would not license the

technology to firm 2 at all.
Outsider patentee and licensing of drastic technology:

If the patent holder is an outsider then it can implement the
monopoly outcome by suitable choice of fixed fee and
royalty and license to any number of firms.
Under drastic technology
By licensing to a single firm the innovator can get
𝑎 𝑐 𝜀
4
Suppose it licenses the technology to two firms under (f, r) contract.
Monopoly price is
Under f, r contract the MC for both firms would be

𝑐 𝜀 𝑟 .
So quantities would be . And the price would be

2 𝑎 𝑐 𝜀 𝑟 𝑎 2𝑐 2𝜀 2𝑟
𝑝 𝑎
3 3
41
To exploit the market fully the r should be chosen such that

the price under duopoly is equal to the price under
monopoly.
Thus, .
This implies 𝑟
The output of both the firms would be =
Hence profit of each firm would be

𝑎 𝑐 𝜀
16
Thus the total payoff to the innovator would be
. =
In fact by suitable choice of (f, r) any number of firms can be licensed and still
monopoly profit can be obtained by the innovator.
Topics left out:

International R&D races
R&D Policy: Subsidy and antitrust issues.
Issues related to patent breadth.
42
References:
Aghion, Philippe, Mathias Dewatripont, and Patrick Rey (1999), “Competition, Financial
Discipline and Growth,” The Review of Economic Studies, vol. 66, pp. 825-852.
Aghion, Philippe, Nicholas Bloom, Richard Blundell, and Peter Howitt
(2002),“Competition and Innovation: An Inverted-U Relationship,” National Bureau of
Economic Research, Working paper 9269, Cambridge, MA.
Arrow, Kenneth J. (1962), “Economic Welfare and the Allocation of Resources to
Invention,” in R.R. Nelson (ed.), The Rate and Direction of Economic Activity, Princeton
University Press, N.Y.
Boldrin, M. and Levine, D., 2004, Rent –seeking and Innovation, Journal of Monetary
Economics, vol. 51, 127- 160.
Cohen, W.M., Nelson, R.R., Walsh, J.P., 2000. Protecting their intellectual assets:
appropriability conditions and why U.S. manufacturing firms patent (or not). NBER
Working Paper 7552.
Hicks, J. R. (1935), “Annual Survey of Economic Theory: The Theory of Monopoly,”
Econometrica, Vol. 3, No. 1., pp. 1-20.
Dasgupta, Partha and Joseph Stiglitz (1980), “Industrial Structure and the Nature of
Innovative Activity,” Economic Journal, vol. 90, pp. 266-293.
Denicolo, V. and Franzoni, L. A., 2004, Patents, secrets and the first inventor defense,
Journal of Economics and Management Strategy, Vol. 13, 517 – 538.
Denicolo, V. and Franzoni, L. A., 2004, The contract theory of patents, International
Review of Law and Economics, Vol. 23, 365 – 380.
Gallini, N. and Wright, B. D., 1990. “Technology transfer under asymmetric information”,
Rand Journal of Economics, 21, 147-160.
Gilbert, R., 2006, Competition and Innovation, Journal of Industrial Organization
Education, BE Press.
Kamien, M., 1992. “Patent licensing”, In Aumann, R. J., and Hart, S. (Eds.), Handbook of
Game Theory, Chapter 11.
Kamien, M. I. and Tauman, Y., 1986. “Fees versus royalties and the private value of a
patent”, Quarterly Journal of Economics, 101, 471-491.
43
Kamien, M. I. and Tauman, Y., 2002, “Patent licensing: the inside story”, The Manchester
School, 70, 7-15.
Katz, M. and Shapiro, C., 1986. “How to license intangible property”, Quarterly Journal
of Economics, 101, (3), 567-589.
Marjit, S., 1990. “On a non-cooperative theory of technology transfer”, Economics Letters,
33, 293–298.
Marjit, S., 1991, Incentives for cooperative and non-cooperative R and D in Duopoly,
Economics Letters, 37, 187-191.
Martin, Stephen (1993), “Endogenous Firm Efficiency in a Cournot Principal-Agent
Model,” Journal of Economic Theory, vol. 59, pp. 445-450.
Motta, M., 2004, Competition Policy: Theory and Practice, CUP.
Poddar, S. and Sinha, U. B., 2008, “On Patent Licensing” , Roberto Cellini and Luca
Lambertini (eds.), The Economics of Innovation: Incentives, Cooperation, and R&D
Policy, Emerald, 33-65.
Poddar, S. and Sinha, U. B., 2010, “Patent Licensing from High-Cost Firm to Low-Cost
Firm” (co-authored with Sougata Poddar) Economic Record.
Schmidt, Klaus M. (1997), “Managerial Incentives and Product Market Competition,” The
Review of Economic Studies, vol. 64, no. 2, pp. 191- 213.
Schumpeter, Joseph A. (1942), Capitalism, Socialism, and Democracy. New York: Harper
and Brothers. (Harper Colophon edition, 1976.)
Sen, D., Tauman, Y., 2007. “General licensing schemes for a cost-reducing
innovation”, Games and Economic Behavior, 59, 163-186.
Sinha, U. B., 2006, “Patent Enforcement, Innovation and Welfare”, Journal
of Economics, Vol. 88, No.3, 211-241.
Scherer, F. M., 1967, "Market Structure and the Employment of Scientists and
Engineers," American Economic Review, 524-531.
Shy, O., 1995, Theory of Industrial Organization: Theory and Applications,
MIT Press.
Tirole, Jean (1997), The Theory of Industrial Organization, MIT Press.
Wang, X. H., 1998. “Fee versus royalty licensing in a Cournot duopoly model”, Economics
Letters, 60, 55-62.
44

My Presentation - Lecture Slide R&D Patent Licensing

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

My Presentation - Lecture Slide R&D Patent Licensing

Uploaded by

Copyright:

Available Formats

Uday Bhanu Sinha Delhi School of Economics

Economics of Innovation, IPRs and Technology

Innovation is at the heart of economic growth and development.

Product innovation: is a new or improved good or service.

1. Innovation and market structure :

Competition and Innovation debate: What’s the relation?

Schumpeterian (1942) view: monopoly has the highest incentive for

 continual R&D leads to periodic waves of new technology that in turn

Monopoly may be better:

Schumpeter’s argument is that most technological innovation would come

However, as John Hicks (1935) famously remarked,

Arrow (1962) challenged the Schumpeterian view.

 a pre-innovation monopolist has a weaker incentive to innovate than a

 when there is competition to innovate, monopolists innovate at a

The opposite view: competition will drive organizations to be more innovative

Reasons: 1) Business stealing effect: there is the possibility of using

make it possible and profitable to diffuse an innovation throughout an industry

In short, a firm facing strong product- market rivalry has an incentive to

q(c0) q(c1) Quantity

qm(c0) qm(c1) Quantity

Monopoly profit with drastic innovation

qm(c0) qm(c1) Quantity

The debate sparked an extensive economics literature on innovation and

Some general observations on the debate:

First: competition in innovation itself encourages innovation.

Second: competition among rivals producing an existing product encourages

Fourth: preemption incentive: a firm will have an extra incentive to innovate

Characteristics of innovation under monopoly

Entry barrier: When barriers to entry are low or non-existent, monopolists

Because of this, theory suggests that monopolists always have incentives to

Which assumption is more appropriate, leapfrogging or step-by-step

Schmidt (1997) and Aghion et al. (1999) : competition makes bankruptcy

Schmidt (1997) : greater competition has two effects:

2. R&D Race and Organization:

The timing of innovation plays a crucial role in the market place.

A firm that is first to discover gain an advantage over competing firm.

If the firm fails then 0 is the return.

Suppose, both firms undertake R&D then

More number of firms means duplication of R&D investment, which may

If one firm undertakes R&D then expected profit αV – I = social surplus.

R&D Organization: (Marjit 1991)

Cooperation is preferred for both higher and lower values of α.

R&D cooperation and spillover:

3. If β< ½ , then xC < xNC and QC<QNC

Intuition: Under Cooperation they would choose R&D investment to

Since R&D cooperation is privately profitable, so no reason to provide

An oligopoly with n firms without spillover (Motta, 2004).

Results: R&D level choice depends on three effects:

Incentives for cooperative R&D:

Other forms of cooperation: Cross licensing and patent pooling

According to US constitution, intellectual property rights are granted in order

There is a general agreement that patent system is useful for encouraging

Two goals of patents:

The second goal of publishing information reduces extra cost of duplication

For patenting an invention must be novel, non-trivial and useful.

Patent plays a minor role in encouraging innovation in some industries such

Patent vs. trade secret

Optimal patent length Issues:

a-c a-c-x Quantity

The innovators profit in T periods

Society’s optimal duration of patent:

Patent enforcement in the context of North-South technology

In a North-South framework, consider a two period model.