License or Entry in Duopoly with Quality Improving Innovation: Alternative Definitions of License Fee

Abstract

We examine the profitability of licensing a technology for producing a higher quality good or the same good at lower cost with or without entry into the market by an outside innovating firm under vertical product differentiation with ex-ante quality choice in duopoly. According to the definition of license fee by Kamien and Tauman (1986), the license with entry strategy is more profitable than the license without entry strategy for the innovating firm. However, the definition by Kamien and Tauman (1986) is inappropriate when the innovating firm has an option to enter the market, and if we adopt an alternative and more appropriate definition, the license without entry strategy is more profitable. We also show that the social welfare when the license fee is determined according to the alternative definition is lower than that when the license fee is determined according to the definition by Kamien and Tauman (1986) because in the latter case, the innovating firm enters the market; on the other hand, in the former case, it does not enter.