In economics, a firm is considered to be “downstream” if it gets the necessary inputs for its product from another firm. For example, a smelter would be downstream from a firm that actually mines ore from the ground.
In the case of intellectual property, a downstream firm is one that, while not a patent holder, uses an upstream firm’s IP to produce its products. In order to do so, it must pay for the rights to do so by obtaining a license.
How broadly an upstream firm should license its products is the subject of a new paper published by the National Bureau of Economic Research:
We study how competition between two downstream firms affects an upstream innovator’s innovation strategy, which includes selecting how much innovation to produce and whether to license this innovation to one (targeted licensing) or both (market-wide licensing) downstream competitors. Our model points to a U-shaped relationship between downstream competition and upstream innovation: at low levels of competition, market-wide licensing is optimal and competition reduces innovation while at high levels of competition targeted licensing is optimal and competition increases innovation. Empirical analysis using a large panel of US data provides clear support for these predictions linking competition, innovation and licensing.
There’s a well-established theory of an “inverted U” curve when it comes to innovation and market competition–highly competitive and highly concentrated markets tend to lead to lower levels of innovation, leading to a sweet spot in the middle to maximize innovation. But this logic applies to competing firms, whereas the authors seek to investigate the optimal behavior of an upstream firm granting rights to downstream ones.
What is the logic for this optimum for a licensing firm? Suppose we have a competitive market. A firm that is able to acquire IP its competitors don’t have is able to extract rents from having a superior product, making it willing to pay a higher price for the edge over its competitors (what the authors call an “offensive advantage.”) This creates an incentive to issue a limited number of licenses.
On the other hand, if licensing is done for all firms in a competitive downstream market, then all firms are able to use the IP, diminishing the opportunity for firms to derive rents, and thus making the license less valuable.
What does all of this have to do with innovation? The entire justification for intellectual property is that monopoly rents are necessary to offset the up-front costs of innovation. Licensing the rights to IP is another way for a firm to make its money back, so greater licensing revenue would, under this logic, increase innovation.
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