To Share or to Compete: Managing Revenue Streams for Innovations in Markets with Network Effects

Abstract

Firms in many technology intensive industries increasingly license innovations to potential competitors besides using them in their own products. Licensing not only creates an additional profit stream, but could also enhance the value of the innovator's own product in a market with network effects. However, it also makes the licensee a potential competitor in the product market. In this paper, we develop a model to understand if, when and how a firm should share its innovation with a rival. Prior models of licensing in such markets have failed to accommodate the impact of the licensor's and licensee's product development capabilities, and the effect of subsequent competition in the product market. We consider vertically differentiated markets with network effects where the performance levels of a firm's product depends both on whether or not it has access to the innovation and its development capability. We show that a firm should license its innovation to a competitor only if the product development capabilities of the two firms are significantly different. Further, the attractiveness of licensing increases with the strength of the network effects. Finally, the optimal form of licensing - royalty, fixed-fee, or two-part tariff - depends on both the network effects and the relative capabilities of the firm. In general, the royalty-based contracts are preferable over fixed-payment contracts when the differentiation between firms is lower and network effects are weaker. Our conclusions lead to a nuanced understanding of royalties as a lever for controlling competition in product markets for firms which are vendors in the technology market as well.

Keywords: technological innovation, licensing, product differentiation, competition, network effects