Licensing and Innovation with Imperfect Contract Enforcement

Innovation and Economic Growth, Intellectual Property, Patents and Competition Policy and Antitrust

Article Snapshot


Eirik Gaard Kristiansen and Richard Gilbert


Journal of Economics & Management Strategy, Vol. 27, No. 2, pp. 297-314, 2018


Weak enforcement of patent license terms might discourage licensor innovation, but encourages licensors to offer lower royalties, lowering consumer prices and promoting innovation by downstream producers.

Policy Relevance

Weak enforcement of contract terms can lead to more innovation overall.

Main Points

  • Innovators often license their technologies to licensees in exchange for royalties; most licensing revenues collected by research centers such as universities come from royalties that vary with licensee product sales.
  • License contracts must be enforced, but enforcement can be difficult and costly; weak enforcement limits the maximum royalty that innovators can charge without tempting licensees to cheat by under-reporting the royalties they owe to the licensor.
  • When downstream licensee firms compete, each firm can attract buyers by cutting prices; cheating becomes more attractive as competition grows, because proportionally greater profits can be earned by cheating and cutting prices.
  • With imperfect enforcement, royalties are lower, reducing downstream consumer prices and increasing licensees’ incentives to invest in improvements to their product; imperfect enforcement will lead to more investment overall.
  • Some licensors address enforcement difficulties by refusing to license technologies to multiple competing licensees; instead, the licensor grants a single exclusive license or vertically integrates its operations with a licensee.
  • Licensors unable to sustain higher royalties by licensing its best technology might choose to develop a technology that allows greater product differentiation by licensees instead, allowing a higher sustainable royalty.
  • Licensees might prefer technologies that allow less downstream product differentiation even though this means greater downstream competition; less differentiation pressures the licensor to offer lower royalties.
  • If a vertically integrated licensor competes with a licensee, the licensor could earn more from product sales than from licensing by lowering the price of its product after the license negotiations are concluded; anticipating this, licensees will only agree to pay reduced royalties.

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