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.