Abstract
In an incumbent–challenger innovation model, this paper examines to what extent licence contracts can internalize the business-stealing and common pool externalities occurring in technological competition. Due to these negative externalities, private R&D investments are higher than the socially optimal ones. Licensing of current technology creates a replacement effect for the challenger and thus induces lower research rates. Special exchange clauses concerning future improvements, which are often used in licensing practice, partially take care of the common pool externality. Although the externalities are not internalized completely, a grant-back clause, requiring the licensee to license back improvements to the original licensor, can achieve a welfare improvement by reducing the R&D investments (in some cases below optimal levels). If there are no restrictions in setting the ex-post licence fee for the improvement, socially optimal R&D investments can be induced. A mutual exchange clause, stating that the original licensor must license an improvement to the licensee and vice versa, induces social underinvestment in R&D.
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