Ad valorem and per unit royalty licensing under Bertrand Competition Nitin Kumar sinha

Abstract: This paper deals with two firms in the Bertrand competition and licensing decision of the innovator firm. When firms compete in price competition then per unit royalty is preferred over the ad valorem royalty by the patentee, as contrast to the Cournot competition. Introduction : The innovation by a firm is always followed by patent licensing. Patent acts a channel for the firms to cash in their innovation. It can be for some fixed time or can be in the form of royalty over production or sales. The literature of patent licensing can be studied in two broad categories : one of internal patentee and second for external patentee. Early literature focused mainly on the innovators who were outside the industry. The early works of Katz and Shapiro(1986) , Kamien and Tauman(1986) established the preference of fixed fees over per unit royalty considering external patentee. However under certain situations per unit royalty was superior over fixed fees if one the incomplete information scenario studied by Gallini and Wright in 1990 and Bertrand competition in differentiated markets studied by Muto in 1993. However the first model on internal patentee was proposed by Wang in 1998 in which he showed that considering the innovator an insider in the industry royalty licensing can be better for the patentee than fixed fees. He also studied the internal patentee case for the Bertrand competition in 1999 and showed that even drastic innovation can be licensed. Oller and Sandonis (2002) studied the two part tariff licensing contracts and also studied the effect of licensing on the welfare. It also showed a counter result of licensing of drastic innovation under Cournot Competition. The royalty on revenues received little attention in theoretical literature although many empirical evidences suggested its presence. It was first studied empirically by Bousquet et al.(1998) through the means of studying data on French firms where they found that about 78% of contracts include royalties and amongst these ad valorem contributed 96% with only 4% by per unit royalties. Bousquet(1998) considered an external patentee and showed that whenever there is uncertainty on the demand side, ad valorem royality are better than per unit royalty. Martin and Saracho(2010) in their paper in 2010 for the first time compared the per unit royalty and ad valorem royalty for internal patentee in which they showed that in a homogeneous Cournot example it is always beneficial for the patentee to go for the ad valorem royalty instead of per unit royalty. They argued that in ad valorem royalty case, the innovating firm will be strategically less aggressive because of the collusion effect which ad valorem induces. They further showed that welfare is smaller in the case of ad valorem royalty than per unit royalty.

We extended this model of Saracho and Martin by comparing in the Bertrand competition with some fixed values of coefficient of substitution and compared the industry output and the welfare in both cases. The remaining section will be as follows. In section 2 we will be presenting our model. In section 3 we will be discussing the output and profit under optimal royalty rate. In next section the case of ad valorem will be discussed and finally in the last section we will be comparing the both royalties. The model: We will assume two firms say Firm 1 and Firm 2 in the market out of which Firm 1 owns the cost reducing innovation and Firm 2 is the potential licensee. We are considering only the case of non drastic innovation in which Firm 1 do not get monopoly power. The marginal cost of production before innovation was constant c which reduces to 0 if the firms go for the adoption of innovation. We are assuming the utility function as follows U(q1,q2) = q1 +q2 - q12/2 q2 2 /2 - q1q2 Where q1 and q2 are the outputs of the two firms respectively and is the coefficient of substitution. For =1 the goods are perfectly substitutable and for = 0 the goods are perfect complement. The direct demand function can be obtained from utility function. They will be of 2 2 the form qi= (1/1+)- (1/1- )pi + (/1- )pj, Where i= 1,2 , j = 1,2 & ij There are three stages of the game. In the first stage Firm1 decides an optimal royalty or ad valorem rate and offer it to the Firm 2. In the second stage Firm 2 decides whether to accept or reject the offer. In the third stage both Firms engage in the price competition. Looking for subgame perfect Nash equilibrium we will solve the model by using backward induction method. Per Unit Royalty: In first stage Suppose Firm 1 decides to go for the per unit royalty. Let h be the per unit royalty charged by the Firm 1.So the problem of the Firm 1 is to maximize the value of h. In the second stage Firm 2 will go for the royalty only when optimal rate is less than or equal to the h. In the third stage both will compete in the price competition. Starting from the third stage in which both Firms will try to maximize their profits given optimal royalty rate. The problem will for Firm 1 will be to maximize its profit 1 = p1q1(p1,p2) + hq2 with respect to the p1 and the Firm 2 will try to maximize its profit 2 = p2(p1,p2)q2 - hq2 . The equilibrium output and the profits for the Firms are given as follows:

q1=

H22L H22L h H12L H42L

q2=

H22 L +h H12L H42L

2H8 72+4L+ hH8+2H8+2LL H2++2L2+ h

1 =

H4+2L2 H1+2L

In the Second stage firm 2 will decide whether to accept or reject the contract. Let Firm B accepted the contract. Then in the first stage Firm 1 would have maximized the royalty rate. The problem of the firm 1 is Max 1 with respect to h subject to conditions obtained in stage 3 and stage 2. The royalty rate should be less than or equal to the decrease in the marginal cost for Firm 2 otherwise Firm 2 will not accept the offer. Firm 1 will try to extract as much royalty as he can by not making offer infeasible for Firm 2 , so he will increase h to maximum extent and the optimal royalty rate will be c. In this the profit of the patentee will be
1Patentee =
2 H8 72+4L+ cH8+2H8+2LL H2++2L2+ c

H4+2L2 H1+2L

And the total industry output will be given as follows:

Qind =

H22L H2 c L H12L H42L

Ad Valorem Royalty: In this case the firm 1 will be charging a rate v on the profit of the Firm 2. The firm 1 will be maximizing 1 = p1q1(p1,p2) + vp2q2 with respect to p1 and the firm 2 will be maximizing 2 = p2(p1,p2)q2 vp2q2. The equilibrium prices will be
p1=
H1L H2++ v L

4 H1+ vL ^2 ,

p2=

4 H1+ vL ^2

H2^2L

In the Second stage firm 2 will decide whether to go for the ad valorem or not. It will not go for the licensing if in this case the profit is lower than that in the case of no licensing. In the third stage firm 3 will maximize its ad valorem rate h inserting for the equilibrium prices obtained in the stage 3 subject to the constraint that 2(ad valorem)> 2(no licensing) with respect h. The constraint will be binding because the Firm 1 will try to increase the v as it will increase the values of price and On solving for this maximization problem we will get an optimal value of the ad valorem royalty given by

v=

2^4H2^2 2c+ 2^2L^2

H2+L^2H23+^2L R K

Where
R=
!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!! ! 64H1L 16H98c 4c2L 2+ 64H2 cL 3 +H3 1 48c+ 24c2L 4 H84 64cL 5 H51 96c+ 48c2L 6+ H9 8cL 7+ H9 16c+ 8c2L 8

K = 96 c3+ 64

2I112+2048 c3M3 +24c7 +I12c+2c2M8+10563cI800 c+16c2MI6080 c+40c2M15

As we tried to understand the profits under ad valorem royalty we will find that it allowed the patentee to take care of the reaction of the other firm in the last stage when they are choosing the price. As prices are strategic complements the innovator is able to limit the price competition at the last stage of the game. On inserting the value of optimal ad valorem rate v we will get the profit expression of the firm1as follows
34 H1+LH2+L2H4+ 4 26LD H L@8 2d6 n i y z j z 1av = j k @H1+LH2+L4 H6 +2L2 H3+ 192 23+ R 4L2D { .

Where d= (2+)^2(2-3+^2)R-K n= 2^4(2- - ^2-2c+2^2)^2

Comparison between Royalty and Ad valorem: On comparing the profit between the two cases using the contour diagram given by Vita E Pensiero(2012), when the value of c closer to 1 then per unit ad valorem is greater than per unit royalty so for these values the profits will be higher. However for lower and intermediate values we will get profit under per unit royalty higher than ad valorem royalty. Taking specific examples c = 0.75 the profits are higher in case of ad valorem. For c = 0.50 the profits are higher in the case of per unit royalty. The result is opposite to that observed in the Cournot competition case. This can be intuitively understood as under per unit royalty the innovator tries to increase its revenues through sales by rival firm in equilibrium which is called quantity effects. In the Bertrand competition the production cost of the Firm 2 is at the same level as that of Firm 1, the higher profits of the firm 2 is absorbed by the Firm 1via ad valorem royalty. This effect is called profit effects. So as long as the former effect dominates the latter effect per unit royalty will be preferred.

Conclusion: We saw that the results which were obtained in the Cournot competition can be reversed in the case of the Bertrand Competition. This is because as long as patentee commits to be less aggressive he will benefit more. In the Cournot context it was the profit effects that dominates and thus ad valorem was more efficient mechanism. In the Bertrand Competition the quantity effects prevails over the profits effect so per unit royalty allows the Firm 1 to set higher price and thus greater profits compared to the ad valorem case. References

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