Licensing cost‐reducing innovations under supply function competition

In this paper, we study the licensing of cost‐reducing innovations in a duopoly under supply function competition. We show that the innovator prefers fixed‐fee licensing to no licensing if its cost advantage is not extremely large. Moreover, if its cost advantage is not extremely small, the innovator prefers fixed‐fee licensing and mixed licensing to revenue‐royalty licensing. This second result arises only because of our assumption that the cost functions are quadratic. We show that if the cost functions are linear and royalty payments are per unit of output, the innovator strictly prefers royalty licensing to fixed‐fee licensing. We also show that in our model, consumer surplus is remarkably higher under any type of licensing than under no licensing. However, revenue‐royalty licensing is slightly superior for consumers to the other two types of licensing and only so if the cost advantage of the innovator is sufficiently large.