The Optimal Scope of the Royalty Base in Patent Licensing

There is considerable controversy about the relative merits of the apportionment rule (which results in per-unit royalties) and the entire market value rule (which results in ad-valorem royalties) as ways to determine the scope of the royalty base in licensing negotiations and disputes. This paper analyzes the welfare implication of the two rules abstracting from implementation and practicability considerations. We show that ad-valorem royalties tend to lead to lower prices, particularly in the context of successive monopolies. They benefit upstream producers but not necessarily hurt downstream producers. When we endogenize the investment decisions, we show that a sufficient condition for ad-valorem royalties to improve social welfare is that enticing more upstream investment is optimal or when multiple innovators contribute complementary technologies. Our findings contribute to explain why most licensing contracts include royalties based on the value of sales. JEL codes: L15, L24, O31, O34. keywords: Intellectual Property, Standard Setting Organizations, Patent Licensing, R&D Investment. ∗The ideas and opinions in this paper, as well as any errors, are exclusively the authors’. Financial support from Qualcomm is gratefully acknowledged. Comments should be sent to [email protected] and [email protected].