Optimal licensing of uncertain patents in the shadow of litigation

- In general markets, we provide sufficient conditions for a licensor of patents with uncertain validity to prefer royalties.
- This is the case for weak patents if the strategic effect of an increase in a licensee's cost on industry profit is positive.
- The latter condition holds in Cournot and Bertrand oligopolies under very general assumptions on demands.
- We develop some new insights into the cost paradox for both Cournot and Bertrand oligopolies.

This paper investigates the choice of a licensing mechanism by the holder of a patent whose validity is uncertain. We provide sufficient conditions of a general nature under which the licensor prefers to use a per-unit royalty contract. In particular we show that this is the case for the holders of weak patents if the strategic effect of an increase in a potential licensee's unit cost on the equilibrium industry profit is positive. The latter condition is shown to hold in a Cournot (resp. Bertrand) oligopoly with homogeneous (resp. differentiated) products under general assumptions on the demands faced by firms. As a byproduct of our analysis, we contribute to the literature on the cost paradox in oligopoly by offering some new insights of independent interest regarding the effects of cost variations on Cournot and Bertrand equilibria.