Network Effects and Technology Licensing: Managerial Decisions for Fixed Fee, Royalty, and Hybrid Licensing

A paramount question faced by technology innovators is whether to license an innovation to other firms, and if so, what type of license it should use. Information technology innovations often have the unique feature of leading to new products and services that exhibit network effects. This paper addresses the question whether the presence of network effects changes an innovator’ licensing choice. The literature suggests that without network effects, a royalty license is preferred by producer-innovators. We find, however, in a market with high intensity of network effects, a fixed fee license is optimal. For low intensity of network effects, the optimal license uses a royalty rate, either alone or in combination with a fee. We further derive the terms of the optimal license and discuss the impact of the investment needed to replicate the innovation and the size of the potential market. Our results provide insights for licensing decisions in industries that exhibit network effects.