Licensing a Vertical Product Innovation*

Abstract

This paper studies the case where an outside patent holder licenses its vertical product innovation to two Cournot competitors. It is found that, under a fixed‐fee contract, the patent holder prefers exclusive licensing. However, under a royalty or two‐part tariff contract, the patent holder favours non‐exclusive licensing. Moreover, in contrast to the standard argument by Kamien and Tauman, we show that, from the perspective of the patentee, royalty licensing can be superior to fixed‐fee licensing, if the degree of innovation is small. Two‐part tariff licensing generates a monopoly outcome in the final market and hence reduces both consumer surplus and social welfare, if the innovation is low.