Per unit vs. ad valorem royalties under asymmetric information

- An incumbent licensor faces uncertainty about the value of the patent to its rival.
- The licensor chooses any two-part fee with either per unit or ad valorem royalties.
- Per unit separating contract or excluding ad valorem contract emerges in equilibrium.
- Per unit royalties alone generate higher welfare than ad valorem royalties.

We study an inside patent holder's optimal licensing policy when it has imperfect information about the value of the patent to its rival. The patent holder can choose any two-part licensing fee with either per unit or ad valorem royalties. We demonstrate that the equilibrium will be either a fully separating contract with different per unit royalty rates, or a contract with a single ad valorem royalty that excludes a high cost rival. Fixed fees will not be used. The presence of asymmetric information uniquely drives the per unit royalties that otherwise would not be adopted. Per unit royalties always generate higher social welfare than ad valorem royalties.