Optimal Patent Policy in the Presence of Vertical Separation

Abstract

We examine the problem of license contracts in vertically separated markets in which the inventor and the manufacturer bargain over royalties in the presence of probabilistic patents and penalty upon infringement. We show that an excessive protection of patent rights can rather delay the introduction of new technology and eventually harm the patent holder's interests. Furthermore, we derive the optimal patent policies which can always maximize social welfare by aligning both parties' incentive to invest; not only can they induce the first-best result in terms of the total wealth but also they allocate the wealth in accordance with the firms' contribution. From the perspective of patent reform, our model supports the application of the entire market value rule to the doctrine of reasonable royalty on the ground that it can always yield the first-best result. We also show that there is room for self-correction in the market even without the optimal policies in that social welfare can be improved to a certain extent by the firms' bargaining over bargaining power.