Rewarding Duopoly Innovators: The Price of Exclusivity∗

We study an environment where a duopoly develops innovations that build on one another. The quality of innovations is private information, so optimal rewards take the form of rights to produce the resulting products. There is a tradeo between encouraging one rm to work on its innovations by granting it promised rights, and the fact that those rights deteriorate the rights of its competitors. We study constrained e cient allocations and show that they result in nearpermanent monopolization: eventually one rm is promised nearly everything, and the competitor is almost completely ignored. This occurs because backloading rewards is an e cient incentive device. We interpret our results in three ways. First, if one thinks of our allocations as o ering policy guidance, then protection is state-dependent as in [1], generating heterogeneity in patent protection in the absence of heterogeneity in innovation opportunities. We show how this protection can be simply implemented by allowing rms to buy additional protection. Second, if the rms are able to contract ex ante, our allocations can be interpreted as a patent pooling arrangement between the rms, where one rm comes to dominate pool membership. Finally, one can interpret the optimal evolution of the duopoly as competition for the market, where static competition is not the key form ∗We thank participants at numerous seminars and conferences for helpful comments. This paper was previously titled Optimal Patent Policy with Recurrent Innovators. †UCLA. ‡University of Toronto.