Intercompetitor Licensing and Product Innovation

Abstract

This article explores how intercompetitor licensing between an incumbent and an entrant affects market competition and the entrant’s optimal product quality. In the model, the incumbent has a noncore technology that is used for the noncore attribute of the final product, and the entrant has a new core technology to introduce a new, higher-quality product. For the noncore technology of its product, the entrant can either license it from the incumbent or develop it in-house. The authors show that a royalty licensing contract of the noncore technology between the incumbent and the entrant has a competition-alleviating effect. More important, the effect of such licensing on the entrant’s optimal quality depends on whether its core technology can significantly or only incrementally increase its product quality over the incumbent’s product quality. The royalty contract will tend to increase the entrant’s optimal quality when the entrant’s core technology can offer a significant quality improvement over the incumbent’s. By contrast, if the entrant’s technology can raise its product quality only incrementally over the incumbent’s product quality, the royalty contract will tend to reduce the entrant’s optimal quality. A wide range of royalty licensing contracts are mutually acceptable; the incumbent (entrant) can benefit from such a contract even when the entrant pays a total royalty fee that is lower (higher) than its alternative research-and-development cost. These results hold even when the incumbent endogenously chooses its royalty licensing fee. The main results are robust to several alternative modeling assumptions (e.g., alternative game sequence, endogenous quality decision by the incumbent, alternative licensing contract).