Licence contracts, future exchange clauses, and technological competition

In an incumbent-challenger innovation model, this paper examines to what ex tent licence contracts can internalize the business-stealing and common poo l externalities occurring in technological competition. Due to these negati ve externalities, private R&D investments are higher than the socially opti mal ones. Licensing of current technology creates a replacement effect for the challenger and thus induces lower research rates. Special exchange clau ses concerning Future improvements, which are often used in licensing pract ice, partially take care of the common pool externality. Although the exter nalities are not internalized completely, a grant-back clause, requiring th e licensee to license back improvements to the original licensor, can achie ve a welfare improvement by reducing the R&D investments (in some cases bel ow optimal levels). If there are no restrictions in setting the ex-post lic ence fee For the improvement, socially optimal R&D investments can be induc ed. A mutual exchange clause, stating that the original licensor must licen se an improvement to the licensee and vice versa, induces social underinves tment in R&D. (C) 2000 Elsevier Science B.V. All rights reserved. JEL class ification: K21; O34.