Innovation Diffusion and Strategic Outside Option in a Bargaining Game

Abstract

We develop an optimal licensing model of a product innovation in which the (external) patent holder negotiates sequentially a two-part tariff contract with two potential licensees that have a positive and strategic outside option. We study the role of this strategic outside option in determining technology diffusion and efficiency of the bargaining. Although rich enough contracts allow the solution of the well known opportunism problem, the strategic outside option of the second negotiator implies deviation from industry profit maximization, which reduces the profitability of nonexclusive licensing. As a result, exclusive licensing still prevails under certain conditions. We extend our analysis to assess the profitability for the innovator to integrate vertically with either firm in the market. The internal patent holder always sells the innovation to the rival non-affiliate as a way to co-opt the latter and improve the profits of the former. As a result, vertical integration as compared with vertical separation may imply a positive quality improving effect. The private and social profitability of vertical integration depends on the type of bargaining between the negotiators and on the distribution of their bargaining power.