The Effects of Downstream Competition on Upstream Innovation and Licensing

Abstract: We consider an upstream innovator and two downstream competitors; and examine the impact of product market competition on the innovator's R&D strategy, when she can license her innovations to either one downstream competitor (targeted licensing) or both (market-wide licensing). We show that downstream competition unambiguously increases the appeal of targeted licensing over market-wide licensing. Moreover, competition increases the innovator's incentives to innovate under targeted licensing, but decreases these incentives under market-wide licensing. Thus, a threshold level of competition may exist such that above (below) that threshold, targeted (market-wide) licensing is optimal and innovation is increasing (decreasing) in competition. Using U.S. data across all industries over the years 1976 - 2006, we find empirical evidence that downstream competition has an U-shaped impact on upstream innovation. Data on licensing deals provides further empirical support that upstream innovators' licensing strategy is the underlying economic mechanism. In particular, as downstream competition intensifies, targeted licensing strategy becomes more appealing to upstream innovators than market-wide licensing.