Licensing of a New Product Innovation with Risk Averse Agents

An outside innovator invents a new product the viability of which is uncertain. The production technology is licensed to a number (strategic choice) of risk-averse potential Cournot producers by means of: an up-front fee, a per-unit royalty, an ad valorem royalty, or a two-part tariff. The incentive to innovate is maximized with a pure up-front fee if potential producers are (or are close to) risk neutral. Otherwise, it is maximized with a combination of up-front fee and ad valorem royalty. Any scheme that contains a royalty component (per-unit or ad valorem) maximizes the innovation diffusion. Irrespective of the magnitude of licensees’ risk aversion, the innovator and consumers are better off, but licensees are worse off with schemes that have an ad valorem royalty component than with a per-unit royalty component. Consumers are best off with pure up-front fee that avoids double marginalization, even though the innovator optimally sells only one license and creates a monopoly. The results remain similar for a risk-averse innovator, but change considerably with a producing innovator.