Price Versus Market Share with Royalty Licensing: Incomplete Adoption of a Superior Technology with Heterogeneous Firms

Abstract

This article shows that the usual result of full adoption of a superior technology induced by pure royalty licensing may not hold when firms have different production technologies. By modeling a Cournot licensing game with an external innovator that offers per-unit royalty contracts to downstream firms, this article shows that full adoption of the innovation occurs only if (1) the new technology is sufficiently more efficient than the best one that is available in the market; or (2) if the firms have similar efficiency levels. Moreover, I disentangle two distinct forces that influence the innovator’s choice: a price effect (PE) and a market share effect (MSE). The former highlights the asymmetry in willingness to pay for the latest technology. The inefficient firms, which benefit the most from the cost-reducing innovation, are willing to pay a higher price to become a licensee than are their efficient rivals. The latter illustrates the innovator’s aim to maximize the volume of royalties that are collected by licensing to many firms. When PE dominates MSE, the patent holder sets a higher royalty rate and attracts fewer, less efficient firms. Otherwise, if MSE dominates, the patent holder reduces the royalty rate and attracts more firms so as to reach as many consumers as possible. From a policy perspective, I show that royalty licensing improves consumer surplus and that the positive effect increases with the number of licensees.