Horizontal licensing in vertically related markets

We study the incentives of a downstream firm that sources its core input from a vertically integrated supplier to license its patented technology to an external firm. Licensing transforms the licensee into both a direct downstream competitor and a customer of the supplier. The vertically integrated supplier trades with his competitors/customers through a two-part tariff contract. We find that the incumbent opts for licensing when the supplier provides the input to both the licensor and the licensee. Although licensing intensifies downstream competition, the licensor benefits from the lower input cost and the supplier from the expansion of the market. Licensing incentives in a vertical market are weaker compared to a one-tier market. Moreover, licensing has a positive impact on both consumer and total welfare. Finally, licensing incentives and welfare enhancement continue to occur under a wider set of conditions such as different types of licensing contracts, input trading contracts and market structures.