Process innovation and licensing

We study optimal licensing and its social welfare implications when the innovator (patentee) is an insider that can make capacity/output commitment so as to act as a Stackelberg leader in the output market. We show that: i) the patentee’s profit-maximizing licensing contract is a royalty; ii) the optimal royalty rate is greater than the cost reduction attained by the licensed technology and is increasing in the number of competitors; iii) optimal licensing maximizes the likelihood of technology transfer, may reduce social welfare and always makes consumers worse off; iv) the innovator benefits from capacity commitment, and the more competitive the output market, the greater the gains it makes by licensing. The opposite holds for consumers.