Inter-Competitor Licensing and Product Innovation

Abstract

This paper studies how licensing of non-core technology between an incumbent and an entrant affects market competition and the entrant's optimal product quality. We show that a royalty licensing contract between the incumbent and the entrant will soften competition. More importantly, the effect of such licensing on the entrant’s optimal quality depends on whether the entrant’s core technology can significantly or only incrementally increase its quality over the incumbent’s product. The royalty contract will tend to increase the entrant’s optimal quality when the entrant’s core technology can allow for a significant quality improvement over the incumbent. By contrast, if the entrant’s technology can raise its product quality only incrementally over the incumbent’s product, the royalty licensing contract will tend to reduce the entrant’s optimal quality. A wide range of royalty contracts are mutually acceptable; the incumbent (entrant) can benefit from a licensing contract even when the entrant pays a total royalty fee that is lower (higher) than its alternative R&D cost. These results hold even when the incumbent endogenously chooses its royalty licensing fee. We show that our main results are robust to several alternative modeling assumptions, e.g., alternative game sequence, endogenous quality decision by the incumbent, and alternative licensing contract.