Per unit vs. ad valorem royalties under asymmetric information

a r t i c l e i n f o JEL classification: D21 D43 D44 D45 Keywords: Patent licensing Insider Asymmetric information Per unit royalty Ad valorem royalty We study an inside patent holder's optimal licensing policy when it has imperfect information about the value of the patent to its rival. The patent holder can choose any two-part licensing fee with either per unit or ad valorem royalties. We demonstrate that the equilibrium will be either a fully separating contract with different per unit royalty rates, or a contract with a single ad valorem royalty that excludes a high cost rival. Fixed fees will not be used. The presence of asymmetric information uniquely drives the per unit royalties that otherwise would not be adopted. Per unit royalties always generate higher social welfare than ad valorem royalties. License structure determines the rents earned by patent holders and, as a consequence, the incentive to distribute innovations and to invest in them in the first place (Shapiro, 1985). In choosing a license structure, patent holders face a critical choice between licensing by fixed-fees, by royalties or by a combination of the two (Kamien and Tauman, 1986). Moreover, if patent holders use royalties, they face the option of those being collected ad valorem or per unit. The choices of how to license and to whom to license influence not only the return on patents but also the likelihood of collusion, the success of competition after the patent expires and the antitrust response (see Rockett, 1990 and Eswaran, 1994). As a consequence, it is not surprising that economists have invested substantial effort in understanding how firms license patents. Typically, an inside patent holder (one that is already producing the product) adopts a royalty in order to put its rivals at a competitive disadvantage. Yet, this finding assumes that the patent holder has full information about how the patent influences its rival's cost (see Sen and Tauman, 2007 and Colombo, 2012 for recent contributions). We argue that this may be unrealistic and, as a consequence, we explore for the first time in the literature an insider's optimal license structure when its Cournot duopoly rival holds private information about its realized marginal cost. At the time of licensing we allow a dichotomous realization of constant marginal cost to be known by the licensee but not the patent holder. Our setting captures several important aspects of patent …