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Licensing interim R&D knowledge. Yossi Spiegel Tel Aviv University. Background. Many licensing agreements are reached in early stages of the R&D process

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licensing interim r d knowledge

Licensing interim R&D knowledge

Yossi Spiegel

Tel Aviv University

background
Background
  • Many licensing agreements are reached in early stages of the R&D process
  • A 1/3 of all licensing deals between the top 12 pharmaceutical companies and biotech firms in 1991-2002 took place during preclinical testing (Kalmas, Pinkus, and Sachs, 2002)
  • Over 60% of all licensing deals between the top 20 pharmaceutical companies and biotech firms in 1997-2002 took place at the discovery and lead molecule phases (Howard, 2004)
  • About 50% of all biotechnology licensing agreements in Lim and Veugelers (2003) were made at the preclinical testing stage
  • The success rate for drugs at the preclinical testing stage is low (about 20% - see DeMasi, 2001)

Licensing interim R&D knowledge

the main idea
The main idea
  • Consider a winner-takes-all R&D contest for developing a new commercial technology (e.g., new drug, new cost effective production process)
  • Question:Should the leader in the contest, before it is decided, hold on to its lead or should it license/sell its superior knowledge to lagging firms?
  • Answer:If the leader can choose between licensing and selling the answer is YES.
  • If it can either license or sell (but cannot select between these two options) the answer is IT DEPENDS.
  • The problem differs from traditional patent licensing because what is licensed is only a chance to invent, not a sure thing (due to Bertrand competition, complete technologies will never be licensed)

Licensing interim R&D knowledge

main effects of licensing
Main effects of licensing
  • Value creation: Raises the prob. that the licensee will succeed when the licensor fails
  • Value destruction: Raises the prob. that the licensee will succeed when the licensor succeeds
  • Rent extraction: The licensor can play the licensees off against one another since a non-licensee faces a lower prob. of being the sole developer of the new technology
  • The rent extraction effect is similar to the blackmail effect in Anton and Yao (AER, 1994; RES, 2002) and to the effect of licensing in Katz and Shapiro (QJE, 1986)

Licensing interim R&D knowledge

related literature
Related literature
  • Kamien (Handbook of IO, 1992) - how should an outsider license a patent?
  • Gallini (AER, 1984) - An insider licenses knowledge to deter entry
  • Rockett (Rand, 1990) - An insider licenses to invite a weak rival
  • Bhattacharya, Glazer, Sappington (JET, 1992) - optimal design of RJV, including cross licensing of interim knowledge
  • d’Aspremont, Bhattacharya, Gerard-Varet (RES, 2000) – bargaining over licensing of interim knowledge under asym. info.
  • Bhattacharya and Gurive (JEEA, 2006) - comparison between patent-based licensing (exclusivity is feasible) and trade-secret-based licensing (exclusivity is not feasible)

Licensing interim R&D knowledge

the model
The model
  • 3 firms engage in an R&D contest, followed by Bertrand competition
  • The profit from being the sole developer of the new technology is 1; otherwise the profit is 0
  • Knowledge: l1 > l2 ≥ l3
  • Knowledge is Blackwell ordered
  • The expected profits absent licensing:

Licensing interim R&D knowledge

exclusive licenses
Exclusive licenses
  • Firm 1 makes take-it-or-leave-it offers to firms 2 and 3 at fees, T2 and T3, and sets a tie-breaking rule in case both firms accept
  • Exclusive license to firm 2 (the case of firm 3 is analogous):

Licensing interim R&D knowledge

nonexclusive licenses
Nonexclusive licenses
  • The expected payoffs:

Licensing interim R&D knowledge

lemma 1
Lemma 1
  • If firm 1 wishes to issue an exclusive license to firm j = 2,3, then it will set T2 and T3 such that

so (accept, accept) is a NE and set a tie-breaking rule that says that firm j gets an exclusive license if both firms accept

  • If firm 1 wishes to issue nonexclusive licenses to both firms 2 and 3, then it will set T2 and T3 such that

so (accept, accept) is a NE and set a tie-breaking rule that says that both firms get licenses if both accept

  • Interestingly, T2* >(<) T3* when l1 < (>) 1/2: firm 2 faces a weaker non-licensee so it values a license more, but it also cares less about being left behind

Licensing interim R&D knowledge

proposition 1 the equil
Proposition 1 – the equil.
  • l1 is large: a license is not worth much to firms 2 and 3 but entails a large loss of technological lead from firm 1’s perspective
  • l1 is intermediate: firm 3 is willing to pay more (T3>T2), but licensing to firm 2 entails a smaller loss of technological lead (firm 2 has a “good” chance anyway)
  • l1 is small: licensing entails a small loss of technological lead (firm 1 is “far away” anyway) and allows firm 1 to play firms 2 and 3 off against one another (a license not only provides knowledge but also ensures that the firm is not left behind)

Nonexclusive

licenses

Exclusive license

to firm 2

No licenses

1/3

1/2

l*1

1

l1

Licensing interim R&D knowledge

partial transfer of knowledge
Partial transfer of knowledge
  • What happens when firm 1 can control how knowledge it transfers?
  • Let D2 ≤ l1 - l2 and D3 ≤ l1 - l3
  • Again, firm 1 makes take-it-or-leave-it offers such that rejection implies that firm 1 will transfer its entire knowledge to the rival firm. The offers are complemented by appropriate tie-breaking rule:

Licensing interim R&D knowledge

partial transfer of knowledge the equil
Partial transfer of knowledge – the equil.

Nonexclusive

licenses

Exclusive license

to firm 2

No licenses

1/3

1/2

l*1

1

l1

Nonexclusive

licenses

Exclusive license

to firm 2

“vacuous” licenses to firms 2 and 3

Licensing interim R&D knowledge

transfer of knowledge between firms 2 and 3
Transfer of knowledge between firms 2 and 3
  • Firm 1 sets T2 and T3 such that p2 = l2(1-l1)2 and p3 = l3(1-l1)2 – the rival obtains an exclusive license
  • p2 + p3 = (l2+l3)(1-l1)2 - firms 2 and 3 benefit from transferring firm 2's knowledge to firm 3 and improve their bargaining positions vis-a-vis firm 1
  • The agreement does not affect firm 1's choice between exclusive and nonexclusive licenses since this choice depends only on whether l1 is above or below 1/3
  • Since l1* with λ₃, the agreement narrows the range of l1 for which firm 1 issues an exclusive license to firm 2

Licensing interim R&D knowledge

firm 1 s knowledge is worth more to firms 2 and 3
Firm 1's knowledge is worth more to firms 2 and 3
  • In many cases, relatively small firms license out their interim R&D knowledge to large corporations (e.g., software industry or biotechnology)
  • Suppose that when firm 1's knowledge is l1, its prob. of developing the new technology is fl1, f∈[0,1]

f

1/3

l*1

1

Licenses

to firms

2 and 3

Exclusive

license to

firm 2

No

licenses

l1

1/2

1

Licensing interim R&D knowledge

correlation
Correlation
  • Suppose that after licensing, the success prob. of firm 1 and its licensee(s) become positively correlated: with prob. r, they are perfectly correlated and with prob. 1-r they are completely independent
  • The expected payoffs under an exclusive license to firm 2:
  • The expected payoffs under nonexclusive licenses to firms 2 and 3:

Licensing interim R&D knowledge

correlation the equil
Correlation – the equil.
  • When r is not too large, the qualitative results of Prop. 1 remain valid:
    • Nonexclusive licenses to firms 2 and 3 when l1* is small
    • Exclusive license to firm 2 when l1* is intermediate
    • No licenses when l1* is large
  • When r is relatively large, things change:
    • Firm 1 will never issue nonexclusive licenses to both firms 2 and 3 whenever
    • Firm 1 will issue an exclusive license to firm 3 whenever l1 < 1/3 and

Licensing interim R&D knowledge

bans on exclusive licenses
Bans on exclusive licenses
  • In some cases, U.S. firms were not allowed to issue exclusive licenses - in two separate consent decrees signed in 1956, AT&T and IBM were required to license their patents on a nonexclusive, world-wide basis to any applicant at a reasonable royalty
  • Bans on exclusive license may backfire!

Nonexclusive

licenses

Exclusive license

to firm 2

No licenses

1/3

l**1

l*1

1

l1

Nonexclusive licenses

No licenses

Licensing interim R&D knowledge

acquisition of knowledge
Acquisition of knowledge
  • Selling differs from licensing because after firm 1 sells its knowledge, it exits the R&D contest (e.g., firm j = 2,3 acquires firm 1 or acquires the relevant R&D lab or division of firm 1)
  • The expected payoffs under exclusive sale of knowledge to firm 2:
  • The expected payoffs under nonexclusive sale of knowledge to firms 2 and 3:

Licensing interim R&D knowledge

acquisition of knowledge the equil
Acquisition of knowledge – the equil.

Nonexclusive

licenses

Exclusive license

to firm 2

No licenses

1/3

1/(2-l3)

1/2

l*1

1

l1

Nonexclusive sale to

firms 2 and 3 if

(l1-l2-l3)(1-2l1) > l1l2l3

or no sale otherwise

No

sale

Exclusive sale

to firm 2

Licensing interim R&D knowledge

sell or license
Sell or license?

Nonexclusive

licenses

Exclusive license

to firm 2

No licenses

1/3

1/(2-l3)

1/2

l*1

1

l1

Nonexclusive sale to

firms 2 and 3 if

(l1-l2-l3)(1-2l1) > l1l2l3

or no sale otherwise

No

sale

Exclusive sale

to firm 2

Licensing interim R&D knowledge

conclusion
Conclusion
  • A leading firm in an R&D contest may be better off licensing or selling its interim knowledge rather then holding on to its lead
  • Selling is particularly attractive when the leading firm is very close to being successful because it allows to avoid competition
  • Licensing/selling is profitable because it may create value and may also allow the leading firm to extract rents from its rivals
  • Exclusive licenses may promote knowledge dissemination especially when the leading firm has a relatively high amount of knowledge

Licensing interim R&D knowledge

possible extensions
Possible extensions
  • Endogenize the success prob. of the three firms
  • Add a second investment stage after licensing takes place - for example, the overall success prob. could be p(li,ti), where ti is the ex post investment
    • In such a model, licensing will allow the licensee(s) to save ex post investments
  • Replace Bertrand competition with some other type of competitive model
  • Make the success prob. private info.
  • Knowledge is non-Blackwell ordered
    • Cross-licensing agreements may emerge

Licensing interim R&D knowledge

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