Licensing a quality-enhancing innovation to an upstream firm

- We examine an outside patent holder license a quality-enhancing innovation to an upstream firm.
- The upstream firm sells its product through a downstream monopoly.
- Two-part tariff licensing is preferred by the patent holder although it might make both consumers and the society worse off.
- Ad valorem licensing is socially efficient.

This paper examines the case where a patent holder who is not a producer licenses its quality-enhancing innovation to an upstream firm, which sells its product through a downstream monopoly. It is found that the patent holder prefers a two-part tariff contract, which includes both a fixed-fee and per-unit output royalty. However, the royalty included in the licensing contract makes each firm price at a markup over marginal cost and therefore makes both consumers and the society worse off, if the innovation is small and the supplier is weak. From a welfare perspective, licensing by means of an ad valorem tax is more efficient, as it allows the upstream firm to be less aggressive when trading with the downstream firm.