Licensing policies for a new product

Abstract

This paper studies licensing policies for the owner of a new product and addresses their welfare impact in the assessment of market failures. We show that the best licensing policy for the patent holder is fixed fee licensing with an exclusive territory clause. Consumers are also better off with fixed fees but do not prefer the exclusive territory clause. Social welfare is higher under exclusive territories when fixed costs are not too large. As for efficiency, the number of licences in the private market equilibrium falls short of the socially optimal solution. Our analysis discloses that (i) any policy measures aimed at enhancing the diffusion of technology, in terms of the number of licences, would be welcomed and, (ii) the permissive treatment received by licensing agreements with exclusive territories is justified.

Keywords:

• Licensing
• Exclusive territories
• Market failure

Acknowledgements

We thank two referees and the editor Cristiano Antonelli for helpful comments and suggestions that improved the final presentation. Rafael Moner-Colonques and José J. Sempere-Monerris gratefully acknowledge the financial support from Spanish Ministerio de Educación y Ciencia under the project SEJ 2004-07554/ECON and Generalitat Valenciana under the project GRUPOS04/13. The views expressed by the former author are not those of the Commission of the European Communities.

Notes

¹Newly developed products often satisfy an already fulfilled need in a more efficient way. Previous costs were too high to render its production profitable. It is in this sense that a product innovation can also be regarded as a process innovation.

²The AUTM survey collects data on licensing activities from US universities, hospitals, nonprofit research institutions and patent management firms as well as from Canadian institutions.

³Mendi (2005) employs data from the Spanish Ministry of Industry Survey about technology purchase up to 1992. The sample includes 212 observations and only 121 contain information about the use of exclusivity provisions.

⁴These six agencies are the National Institutes of Health, within the Department of Health and Human Services; the departments of the Army, the Navy and the Air Force; the Department of Energy and the National Aeronautics and Space Administration.

⁵For example, the Temporally-Ordered Routing Algorithm (TORA), invented at the US Naval Research Laboratory, is the enabling technology on which the NovaRoam 9000 wireless router is based. The NovaRoam 9000 is used to connect computers and exchange data in a wireless environment. The Naval Research Laboratory licensed this technology to Nova Engineering, Inc.

⁶As production of the inferior good is perfectly competitive, then a licensee’s opportunity cost is zero.

⁷See Capozza and van Order (1978) and Greenhut et al. (1987) for a broader analysis.

⁸The boundary between firms is set where the following holds, p+R=p ^*+(1/k)−R where p and p ^* are mill prices of the two neighbour firms, 1/k is the distance between firms when k firms are in the market and R is the radius of the first firm’s market area. Solving for R, we obtain R=(1/2)(p ^*−p+(1/k)). The Löschian conjecture implies that the price reaction of a competitor is unitary, that is, d p ^*/d p=1. Each licensee assumes that neighboring licensees will exactly match its price changes. Thus, d R/d p=(1/2)((d p ^*/d p)−1) and the Löschian case yields d R/d p=0.

⁹We have assumed that consumers transportation costs are linear in distance. However, quadratic transportation costs are usually considered in spatial models to ensure existence of location-then-price equilibria in the standard Hotelling model. In our setting, provided the circumference market, the equilibrium location of licensees is equidistant regardless of the transportation costs type. Assuming quadratic transportation costs implies lower individual consumer demand and also that licensees market power is stronger. It can be shown that equilibrium prices under Löschian competition are greater than under Hotelling competition for the same market radius. Having said that, and since now the market radius that maximizes licensee’s profits is lower, we conjecture that more licences will be sold under exclusive territories. Further note that now consumers will put more weight on saving transportation costs because of more firms in the market that could eventually result in higher consumer surplus under Löschian competition.

¹⁰Further note that there are fixed cost values that imply a monopoly market structure under Hotelling competition, and if they are sufficiently large a monopoly structure arises under both Hotelling and Löschian competition. Then for c=0 and F=10⁻¹, we obtain k ^L=k ^H=1, p ^L=p ^H=1/3, CS^L=CS^H=0.074, and SW^L=SW^H=0.122. These values follow from the monopoly equilibrium outcome which is given by, p ^m=(1+2c)/3, R ^m=(2(1−c))/3, CS^m=(2(1−c)²)/27, SW^m=(2(3−2c)(1−c)²/27)−F.

¹¹The notation superscripts used hereafter are f for fees and w for royalties. Although p ^f and R ^f are equal to p ^L and R ^L as mentioned earlier, we change notation because the Löschian conjecture is used in both the cases of royalties and fees.

¹²Faulí-Oller and Sandonís (2002) show that regardless of competition in quantities or in prices, the optimal licensing contract of a cost-reducing innovation always includes a royalty, very often accompanied by a fee.

¹³The computations can be obtained from the authors upon request.

¹⁴The reader might consult the special IJIO issue on the Economics of Intellectual Property at Universities (November 2003). See Poyago-Theotoki et al. 2002) for a discussion on the increase of university–industry partnerships and the benefits and drawbacks of the commercialization of university research.