The role of short‐term contracts and subsidies in licensing

Abstract

An innovator without production facilities owns a patented invention that lasts two periods, and looks for the best licensing arrangement with a producer that has private information about the market value of the invention. The license is either a single long‐term contract in force over both periods or a series of short‐term contracts, one per period. Under short‐term contracts, the licensee can strategically signal the value of the invention with its level of production in the first period and thus influence the terms of the contract in the second period. We show that the licensor prefers successive short‐term contracts rather than a single long‐term contract for intermediate‐level probabilities of dealing with an efficient licensee, while the first‐period contract may optimally include a per‐unit subsidy (a negative royalty rate) in order to correct signaling distortions in the licensee’s production for this period. We also show that prohibiting such subsidies can lead to welfare losses.