University of Zurich

Department of Business Administration

Chair of Entrepreneurship
Plattenstrasse 14, CH-8032 Z
urich
www.business.uzh.ch

Exercises in Innovation Economics

Daniel Halbheer and Michael Ribers

Part I: Daniel Halbheer

Problem Sets 16
Session Dates: 27.2., 6.3., 13.3., 20.3, 27.3, and 10.4.

Part II: Michael Ribers

Problem Sets 7121
Session Dates: 17.4., 24.4., 8.5., 15.5., 22.5., and 29.5.

My oce hours are on Tuesdays, 5-7 p.m., and by appointment. Email: daniel.halbheer@business.uzh.ch.
My oce hours are on Tuesdays, 5-7 p.m., and by appointment. Email: michael.ribers@business.uzh.ch.
1
Exercises are based on problem sets prepared by Susan Mendez.

List of Exercises
Problem Set 1: A Primer in Oligopoly
4
1.1 Cournot Competition. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4
1.2 Investment in the Cournot Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
1.3 Bertrand Competition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Problem Set 2: Innovation and Market Structure
7
2.1 Monopoly (Tirole, 1988) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
2.2 Competition (Tirole, 1988) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
2.3 Oligopoly. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .11
Problem Set 3: Auctions and Contests
12
3.1 The Vickrey Auction (Mas-Collel et al., 1995) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
3.2 Vickrey Auctions to Choose among Ideas (Scotchmer, 2004) . . . . . . . . . . . . . . . . . . . . . . . 13
3.3 Prototype Contests to Choose among Ideas (Scotchmer, 2004) . . . . . . . . . . . . . . . . . . . . . 14
Problem Set 4: Patents I
16
4.1 Optimal Patent Length (Tirole, 1988) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
4.2 Pooling of Complementary Patents (Motta, 2004) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
Problem Set 5: Patent Races
20
5.1 Research Intensity and Market Structure (Tirole, 1988) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
5.2 Patent Value and the Number of R&D Attempts (Scotchmer, 2004) . . . . . . . . . . . . . . . . 22
Problem Set 6: Research Joint Ventures
24
6.1 Cooperative R&D (dAspremont and Jacquemin, 1988) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
Problem Set 7: Patents II
27
7.1 Patent Breadth and the Ratio Test (Scotchmer, 2004) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
7.2 Optimal Patent Length and Breadth (Gilbert and Shapiro, 1990) . . . . . . . . . . . . . . . . . . . 30
Problem Set 8: Licensing
33
8.1 Licensing Basic Research (Scotchmer, 2004) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
8.2 AntiCompetitive CrossLicensing (Motta, 2004) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
Problem Set 9: Licenses and Litigation
38
9.1 Prot Neutrality in Licensing (Maurer and Scotchmer, 2004) . . . . . . . . . . . . . . . . . . . . . . . 38
9.2 Litigation (Scotchmer, 2004) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
Problem Set 10: Private-Public Partnership
42
10.1 Private-Public Incentives (Scotchmer, 2004). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
10.2 The Government Grant Process (Scotchmer, 2004) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
Problem Set 11: Strategic Patenting, Patent Pools and Mergers
46
11.1 Strategic Patenting (Belleamme and Peitz, 2010) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46

11.2 Patent Pools and Mergers (Belleamme and Peitz, 2010) . . . . . . . . . . . . . . . . . . . . . . . . . . 48

Problem Set 12: Diusion
51
12.1 Diusion (Tirole, 1988) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
12.2 Open Source Software (Belleamme and Peitz, 2010) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53

Problem Set 1: A Primer in Oligopoly

Exercise 1.1: Cournot Competition
Two rms produce homogenous goods and compete in quantities. The industrys (inverse)
demand function is P (Q) = a bQ, where Q is total industry output, equal to q1 + q2 . The
cost function for each rm is given below:
C1 (q1 ) = F1 + c1 q1
C2 (q2 ) = F2 + c2 q2 .
(a) Assuming that F1 and F2 are small, compute the Nash equilibrium.
Firm i solves
max i = P (qi + qj ) qi Ci (qi ).
qi

First-order condition:
i
= 0 a 2bqi bqj ci = 0.
qi
Firm is reaction function is therefore given by
Ri (qj ) = qi =

1
(a bqj ci ).
2b

We thus have two equations and two unknowns. Solving yields

q1 =

1
(a 2c1 + c2 ) and
3b

q2 =

1
(a 2c2 + c1 ).
3b

(b) If c1 > c2 , which rm produces more? Does this depend on the xed costs?
The quantity produced by a rm falls as its own cost increase and rises as
its rivals cost increase. If c1 > c2 , rm 2 will thus produce more. The
production decision does not depend on F1 and F2 (these are paid regardless
of the output level and are not inuenced by a rivals production decision).
If these xed costs were suciently large, however, they might inuence the
rms decisions to produce anything at all.
(c) Graph the reaction functions for c1 = c2 . Suppose c1 rises. Graphically show the eect
in the rms reaction functions and the equilibrium quantities.

Exercise 1.2: Investment in the Cournot Model

Consider two rms that compete in quantities. The (inverse) demand function is given by
P (Q) = 3 Q, where Q = q1 + q2 . Assume that rm 1 makes an observable investment
decision before the rms set quantities. If rm 1 decides not to invest, it pays nothing and
incurs a marginal cost of 1. If rm 1 decides to invest, it pays F > 0 and incurs a marginal
cost of 0. In any event, rm 2s marginal cost is 1.
(a) Compute the equilibrium when (i) rm 1 does not invest and (ii) rm 1 invests. What
is rm 1s prot in each case?
If rm 1 does not invest, both rms solve
max (3 qi qj 1) qi .
qi

In equilibrium,
q1 = q2 =

5
p= ,
3

2
,
3

4
1 = 2 = .
9

If rm 1 does invest, rm 1 solves

max (3 q1 q2 ) q1 F ,
q1

while rm 2 solves
max (3 q1 q2 1) q2
q2

as before. In equilibrium,
q1 =

4
,
3

q2 =

1
,
3

4
p= ,
3

1 =

16
F,
9

2 =

1
.
9

(b) Given your answer in part (a), when will rm 1 invest?

Comparing rm 1s prot in the two cases, rm 1 will invest if and only if
4
12
16
F > F < .
9
9
9
(c) How does the investment decision aect rm 2s output and prot levels?
In Cournot games, quantities are strategic substitutes: if one rm increases
its output, the other rm wishes to decrease its output. By investing, rm 1
reduces its production costs and wishes to produce more (due to the higher
markup); rm 2 thus wishes to produce less, which reduces its prot.

Exercise 1.3: Bertrand Competition

Two rms produce heterogeneous goods and compete in prices. The demand and cost functions
for each rm are as follows:
q1 = 2 2p1 + p2

and

C1 (q1 ) = q1 + q12 ;

q2 = 2 2p2 + p1

and

C2 (q2 ) = q2 + q22 .

(a) Calculate each rms reaction function.

Firm 1 solves
max 1 = p1 q1 (p1 , p2 ) C1 (q1 (p1 , p2 )).
p1

First-order condition:
i
5
= 0 R1 (p2 ) = p1 = 1 + p2 .
pi
12
By a similar calculation, one may obtain rm 2s reaction function
R2 (p1 ) = p2 =

5
5+
+ p1 .
6
12

(b) Given = 1, calculate the equilibrium prices.

Given = 1, R2 (p1 ) = 1 + (5/12)p1 . To determine the equilibrium, solve for
the intersection of the reaction functions:


5
5
1 + p1 ,
p1 = 1 +
12
12
whence follows p1 = p2 = 12/7.
(c) Given = 1, graph the reaction functions.
(d) Suppose rises. Graphically show the eect on the rms reaction functions and the
equilibrium prices.
If rises, rm 2s reaction function shifts rightwards. As a result of the
increase in rm 2s cost, both prices rise (in the Bertrand model, prices are
strategic complements).
(e) What are the Bertrand-Nash equilibrium prices in a market for a homogenous good?
Discuss the intuition. What happens if c1 > c2 ?
If the rms are symmetric, prices pi are set equal to marginal cost c, and each
rms makes zero prot. This result is known as the Bertrand Paradox. In
this case pi = c1 . Note that rm 2 makes a positive prot.

Problem Set 2: Innovation and Market Structure

Exercise 2.1: Monopoly (Tirole, 1988)
Consider a process innovation to understand the monopolists incentive to innovate oered
by the product market. In particular, assume that the innovation lowers the monopolists
(constant) unit production cost from an initial high level cH to a level cL < cH . Let D(p) be
the (downward-sloping) demand for the good produced by the monopoly.
The innovation is protected by a patent of unlimited duration. Letting the constants r and
v m denote the interest rate and the monopolists value of the innovation per unit of time,
respectively, the monopolists pure incentive to innovate is given by

vm
m
.
ert v m dt =
V =
r
0
(a) To construct a benchmark for evaluating the incentives oered by the product market,
consider the rms incentive to innovate when it is run by a social planner.
Show that the social planners incentive to innovate is given by

1 cH
s
D(c)dc.
V =
r cL
The planner sets a price equal to marginal cost, i.e., cH before innovation and
cL afterwards. Thus, the innovation generates an additional net social surplus
per unit of time equal to
 cH
D(c)dc,
vs =
cL

whence follows that

Vs =

vs
.
r

(b) Now assume the monopoly is run by a prot-maximizing owner. Let m (c) be the
monopolists prot when the output is sold at the monopoly price pm (c) given marginal
cost level c.2
Show that the monopolists incentive to innovate is given by

1 cH
m
D (pm (c)) dc.
V =
r cL
Show further that V m < V s and discuss the intuition for this result.
2

The monopoly price pm (c) is a solution to

max m (p, c) = (p c)D(p).
p

Now observe that for each dierent value of c there will typically be a dierent optimal price. We therefore
dene m (c) = m (pm (c), c), which tells us what the optimized value of m is for dierent choices of c.

Hint: Note that


v m = m (cL ) m (cH ) =

cH

cL

dm (c)
dc


dc

and apply the envelope theorem to obtain an expression for the integrand.
From the envelope theorem,
dm (c)
= D (pm (c)) .
dc
To see this, dierentiate
m (c) = m (pm (c), c)
with respect to c:
m (pm (c), c) dpm (c) m (pm (c), c)
dm (c)
=
+
dc
p
dc
c
m (pm (c), c)
.
=
c
Here, the last equality uses the fact that pm (c) is the choice that maximizes
m , so
m (pm (c), c)
= 0.
p
A better way to write this is

m (p, c) 
dm (c)
=
 m .
dc
c
p=p (c)
With this in mind,
d
dm (c)
= (p c)D(p) = D(pm (c)).
dc
dc
Putting the pieces together, we have

1 cH
m
D (pm (c)) dc.
V =
r cL
Note that pm (c) > c, and therefore D(pm (c)) < D(c). Thus, a comparison
of V m and V s reveals that V m < V s . This is easy to understand, because
monopoly pricing at any cost level yields underproduction as compared with
the social optimum. Therefore, the monopolists cost reduction pertain to a
smaller number of units.

Exercise 2.2: Competition (Tirole, 1988)

Consider now a situation in which a large number of rms produce a homogenous good with
a technology exhibiting (constant) unit production costs cH . These rms are initially involved
in Bertrand price competition, so that the market price is cH and all the rms are earning zero
prot. The rm that obtains the new technology cL is awarded a patent of unlimited duration.
The (downward-sloping) industry demand function is denoted by D(p).
Of course, the innovating rms product market price cannot be above cH , which calls for the
distinction of two possible cases: pm (cL ) > cH and pm (cL )  cH . In the second case, in which
the innovation is called drastic or major, the innovating rm enjoys monopoly power and the
other, less ecient rms produce nothing. In the rst case, the innovator is constrained to
charge cH because of potential competition from rms equipped with the old technology. The
innovation is then called non-drastic or minor.
(a) Non-drastic process innovation. Show that the incentive to innovate is

1 cH
c
D (cH ) dc,
V =
r cL
and establish that V m < V c < V s .
In the case of a non-drastic innovation, the innovator is constrained to set a
price equal to cH . His prot per unit of time is given by
 cH
D (cH ) dc.
c = (cH cL )D(cH ) =
cL

Thus, the incentive to innovate in the competitive situation is


1 cH
D (cH ) dc.
Vc =
r cL
We now compare V c to a monopolists innovation incentives.3 Notice that
cH < pm (cL )  pm (c) for all c  cL and thus that D(cH ) > D(pm (cH )).
From this, we derive


1 cH
1 cH
m
m
D (p (c)) dc <
D (cH ) dc = V c .
V =
r cL
r cL
To compare V c to the social planners incentives, observe that D(cH ) < D(c)
for all c < cH , and therefore


1 cH
1 cH
c
D (cH ) dc <
D(c)dc = V s .
V =
r cL
r cL
(b) Drastic process innovation. Show that the incentive to innovate is
1
V c = (pm (cL ) cL )D(pm (cL )),
r
3

Observe that the innovator is a monopolist before innovation and afterwards.

and establish further that V m < V c < V s .

In the case of a drastic innovation, the innovator sets the monopoly price
pm (cL ). His prot per unit of time is given by
c = (pm (cL ) cL )D(pm (cL )).
Thus, the incentive to innovate in the competitive market environment is
1
V c = (pm (cL ) cL )D(pm (cL )).
r
We now compare V c to a monopolists innovation incentives. Using the denition of v m yields
Vm =

1
{(pm (cL ) cL )D(pm (cL )) (pm (cH ) cH )D(pm (cH ))} < V c .
r

Use a graphical argument to show that V s > V c .

(c) Why does a monopolist gain less from innovating than does a competitive rm? Provide
an intuitive explanation.
The result follows from dierent initial situations: The monopolist replaces
himself when he innovates whereas the competitive rm becomes a monopoly.
In the literature, this property is called the replacement eect (due to Arrow,
1962).

10

Exercise 2.3: Oligopoly

Consider a symmetric
 n-rm Cournot oligopoly with a linear inverse demand function P (Q) =
1 Q, with Q = i qi , and constant average cost c.
(a) Show that each oligopolist produces an output equal to
1c
,
q C (n, c) =
n+1
and hence earns a prot


1c 2
C
.
(n, c) =
n+1
Each rm i solves
C
)|qi  0}.
qiC arg max{i (qi , qi
qi

The rst-order conditions are

(1 qiC

qjC c) qiC = 0.

i=j

Applying symmetry (i.e., q C = qiC = qjC ), we have

q C (n, c) =

1c
.
n+1

By substitution,
p(n, c) = 1 nq C =

1 + nc
n+1


C (n, c) =

and

1c
n+1

2
.

(b) Show that the private value of a drastic innovation that reduces cost from c to cL < c is

2 
2
1

c
1
1

c
L

.
V C (n) =
r
2
n+1
Observe that C (1, cL ) is the innovators monopoly prot. Thus, the innovators prot per unit of time is
v C (n) = C (1, cL ) C (n, c).
By substitution,
1
V (n) =
r
C



1 cL
2

2

1c
n+1

2
.

(c) How does V C (n) change with n? Discuss the intuition.

The value of an innovation is increasing in n, so innovation incentives are
larger in more competitive industries. Intuitively, the result reects the fact
that each oligopolist earns a positive prot before innovation takes place. In
case of a successful innovation, the innovating oligopolist partially replaces
himself, which reduces his incentives to undertake R&D (see above).

11

Problem Set 3: Auctions and Contests

Exercise 3.1: The Vickrey Auction (Mas-Collel et al., 1995)
Consider the following auction (known as a second price, or Vickrey, auction). An object is
auctioned o to I bidders. Bidder is valuation of the object (in monetary terms) is vi . The
auction rules are that each player submit a bid (a nonnegative number) in a sealed envelope.
The envelopes are then opened, and the bidder which has submitted the highest bid gets the
object but pays the auctioneer the amount of the second-highest bid. If more than one bidder
submits the highest bid, each gets the object with equal probability. Show that submitting a
bid of vi with certainty is a weakly dominant strategy for bidder i.
Suppose not. Assume bidder i bids bi > vi . Then if some other bidder bids
something larger than bi , bidder i is just as well o as if he would have bid vi . If
all other players bid lower than vi , then bidder i obtains the object and pays the
amount of the second highest bid. If the second highest bid is bj < vi , this results
in the same payo for player i as if he bid vi . However, suppose that the second
highest bid of the other is bj > vi . Then, by bidding bi bidder i will win the object
and obtain a negative payo. By bidding vi he will not win the object and obtain
a payo of zero. Therefore, bidding bi > vi is weakly dominated by bidding vi .
Suppose bidder i bids bi < vi . Then if all other bidders bid something smaller than
bi , bidder i is just as well o as if he would have bid vi . He will win the object and
pay the second highest bid. If some other player bids higher than vi , then bidder
i does not win the object regardless whether he bids bi or vi . However, suppose
that nobody bids higher than vi and the highest bid of the other player is bj with
bi < bj < vi . Then by bidding bi bidder i will not win the object, therefore getting
a payo of zero. By bidding vi , he would win the object, pay bj < vi , and thus
obtain a payo of vi bj > 0. Therefore, bidding bi < vi is weakly dominated by
bidding vi . This argument implies that bidding vi is a weakly dominant strategy.
Thus, each bidder has an incentive to report faithfully his valuation of the object.

12

Exercise 3.2: Vickrey Auctions to Choose among Ideas (Scotchmer, 2004)

We now shed light on the conditions under which the Vickrey auction mechanism identies
the best idea for a targeted objective. From a social planners view, the most attractive idea
would be the one providing the greatest social surplus.
Let the pair (vi , ci ) describe and idea. Dene prospective social surplus of idea i as the
dierence between the observable discounted social value vi /r and the cost ci of developing
the idea into an innovation:
vi
si =
ci .
r
Suppose that the sponsor asks each prospective innovator i to report social surplus si , and
that he chooses the rm that reports the highest surplus to invest. Label the highest and the
second-highest report si and sj , respectively.
(a) Show that by promising a payment of vi /r sj , a sponsor can safely pick the rm that
claims the highest surplus.
If rm i is chosen to invest, it ends up with a prot equal to
vi /r sj ci = si sj .
Using the above result, each rm is weakly dominant strategy is to report
faithfully the surplus si it can deliver. Thus, the sponsor will ask the rm
reporting the highest surplus to invest.
Observe that if si is close to sj , the payment to the winning rm will be close
to cost.
(b) In what sense does the Vickrey auction mechanism yield an ecient outcome? What
happens if the value vi is not observable ex post?
The Vickrey auction mechanism elicits ecient investment in the sense that
the high-surplus rm is chosen to invest, and that there is no duplication of
costs (only the innovating rm pays its cost ci ).
If vi is not observable ex post, payments cannot depend on delivered value.
In that case, the mechanism does not work. However, note that the Vickrey
auction mechanism involves a diculty even in the case of observable values.
If the value delivered is not veriable by a court ex post, the innovator may
fear that the sponsor will renege, or give a smaller price than he deserves,
which will negatively aect investment incentives.

13

Exercise 3.3: Prototype Contests to Choose among Ideas (Scotchmer, 2004)

Here we shall shed light on how the sponsor can circumvent the problem of ending up with
payments depending on the delivered value. The idea is to let the rms demonstrate their
ideas by developing prototypes, and then choose ex post between them.
Assume two rms i = 1, 2 have identical ideas (v, c). Each rm i announces ex ante the price
i at which it is selling the innovation ex post. After naming prices, the rms and the sponsor
write contingent contracts.4 Then, rms invest and deliver prototypes. If rm is prototype is
chosen by the sponsor ex post, it receives the specied price i .
(a) Consider the minimum prices
(1 , 2 ) = (2c, 2c)
to cover costs in expectations (assuming that the tie-breaking rule is to randomize).
Show that these prices cannot be sustained in equilibrium.
The equilibrium bids i are such that neither rm has an incentive to revise
its bid, assuming that the other rms bid is xed. Since each rm would win
with probability 0.5, expected revenues are
1
1
1 = 2 = c.
2
2
Given rm 2 demands 2c in the event it is chosen, rm 1 can improve prot
by reducing its price to 1 = 2c . Then, rm 1 makes prot
1 c = c  > 0
instead of 0. Thus, the prices (1 , 2 ) cannot be sustained in equilibrium.
(b) Let

F () =

(v/r)
1 c

c
(v/r)

if 0   c
,
if c   vr

be the cumulative distribution of the rms prices, and consider the strategies do not
deliver a prototype if the draw turns out to be smaller than the threshold level c and
innovate and demand price if the draw exceeds c. Show that the mixed strategies
F1 = F2 = F are a Nash equilibrium.
The probability that a rm does not innovate is
F (c) = c/(v/r).
If rm 1 develops the innovation and demands any price in [c, v/r], rm 1s
expected prot is
[F2 (c) + 1 F2 ()] c = 0.
This is an equilibrium because each price in the support of the distribution
yields the same expected prot as any other price, namely zero.
Remark: The term [F2 (c) + 1 F2 ()] represents the probability that rm
1 wins the prototype contest. With probability F2 (c) rm 2 does not invest,
and with probability 1 F2 () rm 2 invests but demands a higher price than
does rm 1.
4

The contracts ensure that inventors are not subject to hold-up.

14

(c) In what sense do prototype contests yield an inecient outcome?

With positive probability, the sponsor does not get the innovation, and even
if he gets it, there is a large probability that the costs will be duplicated. This
is the social price for the inability to observe or verify value.

15

Problem Set 4: Patents I

Exercise 4.1: Optimal Patent Length (Tirole, 1988)
An industry is initially competitive. The price is equal to the rms marginal cost, c. The
industrys demand function is D(p) = 1 bp, with b > 0. Assume that one rm has access
to a cost-reducing technology which allows production at marginal cost c < c by spending
(c) = K(
cc)2 /2, with K suciently large so that the process innovation remains nondrastic.
The new technology is implemented at time 0, and the patent lasts T units of time (after which
the technology c can be used freely be all rms). The rms compete a` la Bertrand, and the
rate of interest is r.
(a) Denote by c c the magnitude of the cost reduction chosen by the rm that
implements the new technology. Show that
( ) =

D
,
rK

c.
where 1 erT and D 1 b
Hint: The rm will choose so as to

 T
K2
rt
.
(1 b
c)e dt
max

2
0
Given patent life T , the inventor chooses the that maximizes the dierence
between the benets of implementing the new technology and the cost of
R&D:

 T
K2
rt
(1 b
c)e dt
max

2
0


 T
2
K
rt
(D 1 b
c)
e dt
= max D

2
0


K2

D
.
( 1 erT )
= max

r
2
The rst-order condition reads
D
K = 0,
r
which implies
D
.
rK
Observe that ( ) is increasing in (and hence T ), so that a longer patent
life will lead to a higher cost reduction.
( ) =

16

(b) Show that the new technology increases welfare by


W ( ) =
0

(1 b
c)ert dt

K2
2


+

1
r




b
D( ) + ( )2 .
2

Hint: The generated consumer surplus is equal to





 
b
1
b
2
rt
2
D( ) + ( ) .
D( ) + ( ) e dt =
2
r
2
T
Use a graphical argument to derive the formula for the generated consumer
surplus. Note that the rms prot is part of the consumer surplus after the
patent expires (redistribution).
(c) Show that optimal patent life, , lies in (0, 1), so the optimal patent length T is nite.
Hint: From the envelope theorem,


 T
( )D
K2
d
max
=
.
(1 b
c)ert dt

d
2
r
0
Optimal patent life, , is a solution to



1
dW ( ) ( )D
=
+
D ( ) + b( ) ( )
d
r
r


b
1
2
D( ) + ( ) = 0.

r
2
Substituting ( ) and  ( ), the rst-order condition simplies to
3
f ( ) := b 2 + (rK b) rK = 0.
2
Note that f (0) < 0 and f (1) > 0. As f ( ) is a convex function, the (positive)
solution lies in the interval (0, 1). Thus, the optimal patent length is nite.
Remark: Although the size of the innovation is positively related to patent
length, patent life shouldnt be set at an innitely large number. The reason is
the need to balance o the benets of a larger invention against the ineciency
of monopoly pricing.

17

Exercise 4.2: Pooling of Complementary Patents (Motta, 2004)

To produce a certain (homogenous) nal good, n manufacturers need two complementary
technologies, whose patents are owned by two rms A and B, who separately license the
technologies at a unit royalty fee wi (i = A, B). The game is as follows. In the rst stage, the
patentholders independently and simultaneously decide the royalty level. In the second stage,
the manufacturers compete `a la Bertrand, and incur unit costs c + wA + wB , where c < 1.
They face market demand q = 1 p (as usual, if several rms all charge the same lowest price,
demand is equally shared among them; zero demand goes to rms having higher prices).
(a) What are the equilibrium values of royalties and prices? Calculate each patentholders
equilibrium prot.
In the last stage, given that manufacturers compete in prices, the Bertrand
equilibrium applies: the market price will be
p = c + wA + wB ,
and nal demand
q = 1 (c + wA + wB ).
In the rst stage, each patentholder decides the royalty fee so as to
max i = wi (1 c wA wB ).
wi

From i /wi = 0, it follows that the symmetric equilibrium royalty rate is

w =

1c
,
3

and the nal price (by substitution) is

p =
Patentholders prots are
=

2+c
.
3

(1 c)2
.
9

(b) Consider an alternative situation where the two patentholders assign the right of exploitation of their patents to a patent pool. It is now the pool which sets the value of
both royalties. Find equilibrium values of royalties and nal prices under the patent pool
and compare them with the previous case. What is the equilibrium prot of the patent
pool?
Under the patent pool, there is joint-prot maximization of the patentholders.
The pools problem is therefore to
max P = wA (1 c wA wB ) + wB (1 c wB wA ).

wA ,wB

Solving the rst-order conditions gives the symmetric solution

wP =
18

1c
.
4

By substitution, the market price is

pP =

1+c
,
2

and the pools total prot is

P =

(1 c)2
.
4

(c) Show that forming the patent pool is both protable for the patentholders and good for
consumers.
It is straightforward to see that the patent pool Pareto dominates the situation
where the two patents are licensed independently. Final prices (as well as
royalties) are lower (therefore, consumers are better o) and patentholders
prots are higher. Observe that manufacturers in this example always get zero
prots.

19

Problem Set 5: Patent Races

Exercise 5.1: Research Intensity and Market Structure (Tirole, 1988)
Consider a symmetric patent race involving n rms, which initially make no prot. Each of the
rms has a private value V of the patent. Patent life is innitely long, time is continuous, and
the rate of interest is r. The probability of success by rm i at given time, t, is an exponential
function: If ti represents rm is (random) success date, then Prob {ti  t} = 1 ehi t .5 The
choice variable for each rm i is a ow of expenditure xi that yields a probability of discovery
hi = h(xi ) per unit of time. Assume that h > 0, h < 0, h(0) = 0, h (0) = +, and
h (+) = 0.6
(a) Let rm 1 choose expenditure y x1 , and let rms 2, 3, . . . , n choose expenditure
x xi . Show that the probability that none of the rms has discovered by time t is
e[h(y)+(n1)h(x)]t .
The probability that rm i has not discovered until time t is
P r{ti  t} = 1 P r{ti  t} = ehi t .
Thus, assuming independence of R&D activities, the probability that none of
the rms has discovered until time t is
eh(x1 )t eh(x2 )t ... eh(xn )t = e[h(y)+(n1)h(x)]t .
(b) Show that rm 1s expected intertemporal prot is
h(y)V y
.
h(y) + (n 1)h(x) + r
Hint: Note that

[h(y)V y]e[h(y)+(n1)h(x)]t ert dt =
0

h(y)V y
.
h(y) + (n 1)h(x) + r

Suppose that none of the rms has discovered before time t. By spending
amount y on R&D, rm 1 is the rst to innovate with probability h(y), and
earns, starting from that moment, V . Thus, rm 1s present discounted value
of the expected prot over time is

h(y)V y
.
[h(y)V y]e[h(y)+(n1)h(x)]t ert dt =
h(y)
+
(n 1)h(x) + r
0
Note that hi is the conditional probability of success, given no success to date. Further, the expected time
till success for rm i is the reciprocal of the hazard rate; that is E(ti ) = 1/h(xi ).
6
This assumption of a memoryless R&D technology implies that a rms probability of making a discovery
and obtaining a patent at a point in time depends only on this rms current R&D experience and not on its
past R&D experience.
5

20

(c) Show that the rst-order condition for the symmetric Nash equilibrium expenditure is
given by
[(n 1)h(x) + r][h (x)V 1] [h(x) h (x)x] = 0.
Assume that the left-hand side of the rst-order condition strictly decreases with x.
Show that there exists a unique equilibrium research intensity x (n).
Hint: Focus on a symmetric equilibrium with y = x.
Dierentiating with respect to y, we obtain the rst-order condition
[(n 1)h(x) + r][h (y)V 1] h(y) + h (y)y = 0.
Imposing symmetry, we obtain
[(n 1)h(x) + r][h (x)V 1] [h(x) h (x)x] = 0.
Observe that the left-hand side of the preceding equation is positive at x = 0
(because h (0) = +) and negative at x = + (because h () = 0 and
h < 0). Hence, there exists a unique equilibrium research intensity x (n).
(d) Suppose that the objective function is strictly concave. Show that
dx (n)
> 0.
dn
Provide an intuitive explanation for the result.
From the implicit function theorem, we know that
h(x )[h (x )V 1]
dx (n)
=
.
dn
[]
Here, [] denotes a negative expression (the negativity follows from the secondorder condition). From the concavity of h and the fact that h(0) = 0,
h(x) > xh (x).
Therefore, the rst-order condition implies
h (x )V 1 > 0.
We thus get

dx (n)
> 0.
dn

21

Exercise 5.2: Patent Value and the Number of R&D Attempts (Scotchmer, 2004)
Let the triple (v, c, p) denote an idea, where v is the value of achieving the specied objective,
c is the cost of the research approach, and p is the probability that the approach fails. Although
the ideas are symmetric, we assume that the innovators employ dierent approaches, so that
the successes and failures of the dierent attempts are independent. Therefore, if n approaches
are taken, the probability that all of them fail is pn , so that the probability of at least one
success is 1pn , which is denoted by P (n).7 Let r denote the rate of interest, and let S = v/r
denote the social value of the innovation. Further, let denote the patent value and assume
that  S.
(a) Show that the equilibrium number of rms that enter the patent race, ne , satises
1
P (ne )  c.
ne
For each n, the expected per-rm prot is
1
P (n).
n
Firms will enter the patent race up to the point where an additional rm would
not make prot. Thus, ne satises
1
P (ne )  c.
ne
(b) Show that the social optimal number of entrants, n , satises
S[P (n ) P (n 1)]  c  S[P (n + 1) P (n )].
The social value provided by the nth entrant is
S[P (n) P (n 1)] c.
The social optimal number of participants, n , can be described as the number
where the marginal entrant would add as much social value as social cost c,
but his or her successor would not:
S[P (n ) P (n 1)]  c  S[P (n + 1) P (n )].
(c) Why do the private and the social incentives to enter the patent race dier? Provide an
intuitive explanation.
The reason is that the marginal entrant receives the average prot rather than
the marginal prot, but it is the marginal prot that determines the optimal
number of participants (this problem is usually discussed as the problem of
the commons).
In our setting, the average prot is greater than the marginal prot due to
the concavity of P (). Thus, the private value of entry can be positive even
if the social value of entry is negative.
7

Note that, in contrast to the previous model, a failure does not lead to a renewal of eorts.

22

(d) Show that the patent value to induce the optimal number of attempts should be
chosen such that
P (n ) = cn .
Hint: Graph the functions P (n)S and P (n) as a function of n.
See Figure 4.2 in Scotchmer (2004).

23

Problem Set 6: Research Joint Ventures

Exercise 6.1: Cooperative R&D (dAspremont and Jacquemin, 1988)
Consider a duopoly selling a homogenous product. Let the inverse market demand function be
p = a Q, where Q = q1 + q2 is the total production and a > 0. Each rm has marginal costs
ci = c xi xj , where xi is the amount of research that rm i undertakes, and [0, 1]
is a parameter indicating the spillover that results from the R&D investment xj made by the
other rm.8 The cost of R&D is given by
(xi ) =

g 2
x ,
2 i

with g >

4
.
3

We consider two dierent two-stage games, in which the investments xi are the strategies of
the rst stage, followed by the quantities qi in the second stage.
(a) Competition in both stages (let the superscript C denote competition).
(i) Show that the Nash-Cournot equilibrium output is given by
qiC =

a c + (2 )xi + (2 1)xj
.
3

At the last stage of the game, each rm i chooses qi so as to

max (a qi qj ci (xi , xj )) qi .
qi

Note that the prot-maximization problem is the same as in a typical

(one-shot) Cournot game with heterogenous rms. Therefore,
a 2ci (xi , xj ) + cj (xi , xj )
3
a c + xi (2 ) + xj (2 1)
.
=
3

qiC (ci (xi , xj ), cj (xi , xj )) =

(ii) Show that the unique (and symmetric) R&D level for each rm is given by
xC =

2(a c)(2 )
.
9g 4 2 + 22

2
Recall that each rms product-market prot is equal to qiC . Thus,
each rm chooses xi to


a c + xi (2 ) + xj (2 1) 2 g 2
xi .
max i (xi , xj ) =
xi
3
2
8

When the rival invests xj , it is as if rm i had done that investment itself and reduced its cost by xj .

24

By taking the rst derivative and applying symmetry (xi = xj = xC ) one

obtains xC as given above.
Remark: Note that the second-order condition requires g > 2(2 )2 /9.
The stability conditions for the R&D stage require (see, e.g., Shapiro,
1989, p. 335)


 2(2 )(2 1) 
2 i /xi xj
<1

= 
2(2 )2 9g 
2 i /x2i
and are satised for

2(2 )( 1)
3
A sucient condition for stability to be met is that g > 4/3, which also
satises the second-order condition.
g>

(iii) Show that

qC =

3(a c)g
9g 4 2 + 22

and

C =

(a c)2 g(9g 8 + 8 22 )
(9g 4 2 + 22 )2

The results follow by substitution.

(iv) Show that consumer surplus and welfare are given, respectively, by
CS C =

18(a c)2 g2

(9g 4 2 + 22 )2

and

WC =

4(a c)2 g(9g 4 + 4 2 )

(9g 4 2 + 22 )2


Recall that CS C = a pC QC /2 and that W C = CS C + 2 C . The
results then follow by substitution.
(b) The Research Joint-Venture (let the superscript J denote Joint-Venture).
(i) Show that maximizing joint prots at the rst stage of the game yields
xJ =
Hint: Maximize

2

i=1 i (xi , xj )

2(a c)(1 + )
.
9g 2(1 + )2

and focus on the symmetric equilibrium.

The rms solve




2

a c + xi (2 ) + xj (2 1) 2 g 2
xi .
max =
x1 ,x2
3
2
i=1

Taking rst derivatives and focusing on the symmetric equilibrium, the

result follows.

25

(ii) Show that

qJ =

3(a c)g
9g 2(1 + )2

and

J =

(a c)2 g
.
9g 2(1 + )2

The results follow by substitution.

(iii) Show that consumer surplus and welfare are given, respectively, by
CS J =

18(a c)2 g2
(9g 2 4

22 )2

and

WJ =

4(a c)2 (9g 1 2 2 )

(9g 2 4 22 )2


Recall that CS J = a pJ QJ /2 and that W J = CS J + 2 J . The
results then follow by substitution.
(c) When spillovers are large enough, that is,  1/2, dAspremont and Jacquemin (1988)
show that (i) xJ > xC , (ii) q J > q C , and (iii) W J > W C . Provide an intuitive
explanation for these results.
See dAspremont and Jacquemin (1988).

26

Problem Set 7: Patents II

Exercise 7.1: Patent Breadth and the Ratio Test (Scotchmer, 2004)
In a protected market, that is, a market shielded from competition (either naturally, by rms
colluding, government intervention, or labour unions), there is an innovator and a number of
imitators that potentially enter the market. Entry is assumed to be costly. If no entry occurs,
the innovator sets the monopoly price. In contrast, if entry occurs, the imitators can sell their
product as perfect substitutes for the patented technology and the price would be lower than
the monopoly price but higher than the competitive price (pm > p > pc ) since entry is costly.
Furthermore, assume that the market demand is given by x(p) and that marginal production
costs are normalized to zero.
(a) Let K be the cost of entering the protected market and assume that there are n active
rms in the market (including the innovator). Given discounted patent length T , nd
the condition at which entry stops expressed by K, T, x(p(n)), p(n).
Hint: Entry occurs as long as an additional entrant makes a positive prot.
Because we assumed symmetric marginal cost for all rms, each active rm
produces the same quantity. Therefore, the prot of each entrant is the
aggregate prot, x(p(n))p(n), divided by the number of rms, n, minus entry
cost, K. Entry stops when rms are making positive prots and one additional
entrant makes prot turn negative:
1
1
[T x(p(n + 1))p(n + 1)] K < 0  [T x(p(n))p(n)] K
n+1
n
(b) Interpret patent breadth as the cost K of entering the protected market. K can be
duplication cost for inventing around the protected technology or, alternatively, as a
licensing fee charged by the patentholder to allow entry. Does it make a dierence which
interpretation is used? Discuss this issue from the point of view of the patentholder.
The patent holding rm would prefer licensing, because by charging a license
fee of K, it can at least earn (n 1)K and compensate part of the loss from
giving up its monopoly position.
(c) Put yourself in the social planners shoes and assume that K is large enough to cover
the patentees cost. Let

ert dt
T =
0

denote discounted patent length from time 0 to , and suppose that there are two policies
to choose from: (T m , K) is a short enough patent, so that no single competitor enters
the market, but long enough to cover the patentholders cost. (T c , K) is a long lived
patent that allows entry in the protected market.
Let the discounted prot of the patentholder be m = pm x(pm )T m under the policy
= px(
p)T c under the policy (T c , K). Graphically illustrate the per-period
(T m , K) and
prot of the patentholder and the deadweight loss caused by each policy.
27

The prot of the patentholder and the associated deadweight loss can be seen
below (lled for the short lived patent):
p

pm
p

x(p m )

x( p)

(d) Which policy will consumers prefer?

Hint: Use the Ratio Test and proceed along Technical Note 4.7.1 (Scotchmer 2004).
Dene consumer surplus as a function s(p) and deadweight loss as l(p) for all p.
It is an assumption in the Ratio test that both policies are equally protable for
the rm.
Consumers are better o with the policy that generates a larger consumer
surplus. They will prefer policy (T c , K) to (T m , K) if




1
1
c
c
m
m
m
T s(0) > T s(p ) +
T
p) +
s(0).
(S1)
T s(
r
r
Rearranging, we have
p) s(0)) > T m (s(pm ) s(0)) ,
T c (s(
or, equivalently,
p)) < T m (s(0) s(pm )) .
T c (s(0) s(
In exercise (c), we saw that the sum of the prot and the deadweight loss
is equal to the loss in consumer surplus. Thus, we can write s(0) s(p) =
px(p) + l(p) for p [0, pm ]. Inserting this above gives us:
px(
p) + l(
p)] < T m [pm x(pm ) + l(pm )] .
T c [
Making use of the fact that both policies are equally protable if pm x(pm )T m =
px(
p)T c , we can rewrite the above condition as
px(
p) + l(
p)] <
T c [

px(
p)T c m
[p x(pm ) + l(pm )] .
pm x(pm )
28

Rearranging terms, the condition boils down to

px(
p)
pm x(pm )
<
m
l(p )
l(
p)

(S2)

The policy that generates lower prices p is (T c , K) and it is preferred by the

consumers if inequality (S1) holds. This is the case if and only if (S2) holds,
where in each period the ratio of prot to deadweight loss is greater.

29

Exercise 7.2: Optimal Patent Length and Breadth (Gilbert and Shapiro, 1990)
A social planner aims at nding the optimal combination of patent length and patent breadth.
Let T denote patent length and suppose that patent breadth, , is the ow rate of prot that
the patentee obtains during patent protection. Assume that a broader patent increases the
patentees market power and therefore the associated deadweight loss. In other words, if we
let W () denote the per period social welfare, we have W  () < 0. When a patent expires,
= W (
the ow of prots decline to
and social welfare rises to W
). Time is continuous and
the interest rate is r.
The social planners goal is to maximize total social welfare (T, ) by optimally choosing
T and subject to achieving a cost-eective reward for the innovation with value V , that is
V (T, )  V where V (T, ) is the patentholders total discounted prot.
Assume for simplicity that the social planner observes a stationary and predictable environment,
that is there is only one innovation and no uncertainty about future conditions.
(a) Write down the discounted social welfare and the present value of the patentees prots
as functions of T and .
Hint: (T, ) is the discounted social welfare during patent protection plus the discounted social welfare after the patent expires. The present value of the patentees prots V (T, ) is the sum of the discounted prots obtained during patent
protection and the discounted prots after patent expiration.
Discounted social welfare and the present value of the patentees prot are
given by
T

rt
ert dt
(T, ) = W ()e dt + W
0

and

T
V (T, ) =

rt


dt +

ert dt,

respectively.
(b) Dene = (T ) as the ow of prots needed to obtain V . For a given T > 0 we can
then write V as:
T

ert dt.
V (T )ert dt +
0

Solve the integral and dierentiate with respect to T to nd an expression for  (T ).

Solving the integrals in V

T

(T )ert dt +

ert dt, we nd

erT
1 erT
+

.
r
r
Dierentiating with respect to T yields
V = (T )

) +  (T )
0 = erT ((T )
30

1 erT
,
r

which can be rewritten as

)
 (T ) = erT ((T )

r
.
1 erT

(S3)

(c) Show that social welfare is given by

(T, ) = W ()

rT
erT
1
e
+ W () + W
.
r
r
r

Derive the rst-order conditions.

Total welfare is given by
T

rt

W ()e

(T, ) =
0


dt +

ert dt
W

rT
1
erT
e
+ W () + W
.
= W ()
r
r
r

The rst-order conditions read:



erT = W () W
erT
=W ()erT W
T
erT
1
1 erT

= W  ()
+ W  () = W  ()
.

r
r
r

(S4)
(S5)

(d) Show that d/dT > 0 when the ow of prots is set optimally = (T ). If welfare
increases with patent length, how long should patent length be?
Hint: Note that the welfare function can be rewritten as (T, (T )) by construction.
Use the chain rule to nd

d
=
+
(T ).
dT
T

Then make use of the results obtained in (b) to substitute for the expression
 (T ). Finally, assume that patent breadth is increasingly costly in terms of social
, (T )]. Graph the welfare function
welfare, i.e. W  () < 0 and W  () < 0 on [
to understand the argument.
Using (S3), (S4), and (S5) we nd

d 
W  ((T ))((T )
= W ((T )) W
) erT .
dT
The concavity of the welfare function implies (graph the welfare function to
see the argument)

W ((T )) W
> W  ((T ))
((T )
)
or equivalently:
W ((T )) < W  ((T ))((T )
).
W
31

Thus, d
dT > 0 and increasing T always has a positive eect on welfare, so the
optimal patent length is innite. The idea is that increasing patent breadth
raises market power and hence deadweight loss. Therefore, increasing the
reward on a ow basis is costly in terms of social welfare.
(e) Why might this result not apply in practice? Discuss.
An innitely-lived patent is optimal under a predictable and stationary environment. If the environment is not predictable and there is uncertainty
about future demand and costs, risk averse rms might prefer shorter and
broader patents in order to share risk. In an non-stationary environment, Cumulative innovation plays an important role. Since inventions build on each
other, patents with innite length is likely to have deterrent eects on rms
incentives to invest in related research.

32

Problem Set 8: Licensing

Exercise 8.1: Licensing Basic Research (Scotchmer, 2004)
Consider two independent rms. Firm 1 produces a basic innovation and rm 2 has an idea for
a second-generation product that emerges with no delay after the rst innovation is made.9
The per-period value of the rst innovation to end users is given by x and the per-period
increment to market value generated by the application is y. Let c1 and c2 represent the cost
of undertaking basic research and to develop the second-generation product, respectively. The
interest rate is r and T denotes the discounted patent length. Further let and l denote
fractions of the total per-period value to end users. That is, (x + y) is the per-period prot
at the proprietary price (due to patent protection) and l(x + y) is the deadweight loss.10
(a) Suppose that a governmental institution has both ideas. Further suppose that it nances
the innovations through a lump-sum tax and oers the product for free. Write down the
social value obtained from both innovations, W .
If both innovations were public and sold at price p = 0, the social value is
maximal (as there is no deadweight loss). In that case:
W =

x+y
c1 c2 .
r

(b) Write down the social value, W p , and consumer surplus, S p , obtained when the innovations are performed by the two rms under the patent regime.
The social value when both innovations are performed by the two rms is the
discounted total value to end users less the deadweight loss due to patent
protection, and less invention cost. Therefore,
Wp =

(x + y)
(x + y)lT c1 c2 .
r

The consumer surplus is given by

Sp =

(x + y)
(x + y)(l + )T c1 c2 .
r

(c) Suppose the rms coordinate their R&D activities. What is their joint prot, ?
The rms obtain a fraction of the value generated by both innovations
during patent protection less the cost of turning both ideas into innovations.
Hence,
= (x + y)T c1 c2 .
9
Assume that most of the prot is due to the second-generation product and both rms have blocking
patents on the application.
10
Thus, 1 l is the fraction of (x + y) dening consumer surplus.

33

(d) Now suppose the rms do not coordinate their research activity but instead the rms
can either sign a license agreement ex-ante, before the second innovator invests c2 (but
after the rst innovation has been made), or ex-post, after the second innovator invests
c2 . Illustrate the bargaining situation.
An illustration of the bargaining situation is seen below (including payos that
will be explained in the following exercises):
Ex-ante
license?
Yes

No

Payoffs with licence:

T x c1 + 12 Ty, 12 Ty c2
or
1
1
T x c1 + 2 ( Ty c2 ), 2 ( Ty c2 )

Firm 2:
invest?
Yes

No

T x c1 , 0

Ex-post
license?
Yes

T x c1 + 12 Ty, 12 Ty c2

No

T x c1 , c2

(e) In the game, each rms threat point is dened as the expected prot it can guarantee
itself if it does not license. Find the threat points and bargaining outcome for each rm
at the ex-post licensing node under the assumption that the bargaining surplus is split
equally. Indicate the pay-os in the diagram.
Ex-post, the producer of the basic innovation has a threat point of T x c1
and the second generation producer has a threat point of c2 . The bargaining
surplus is T y and it is shared equally between the rms. Payos can be seen
at the bottom of the diagram in exercise (d).
(f) Find the threat point and bargaining outcome for each rm at the ex-ante licensing node
under the assumption that the bargaining surplus is split equally. Indicate the payos in
the diagram.
Following failed ex-ante licensing negotiations, rm 2 is better o by investing than not investing if 12 T y c2 > 0. The thread points at the ex-ante
bargaining node are therefore T x c1 + 12 yT and 12 yT c2 for rms 1
and 2 respectively. Since the rms are bargaining for T x c1 + yT c2
there is nothing left to divide and the bargaining surplus is zero. The ex-ante
licensing agreement payos are simply the thread points as indicated in the
rst line of the upper-left branch on the diagram in exercise (d).

34

On the other hand, the costs c2 could be so high that 12 T y c2 < 0. Firm
2 then anticipates that it will be held up ex-post and that it will not be able
to cover costs. Firm 2 will therefore not invest following failed negotiations
for ex-ante licensing. The thread point are then given by T x c1 and 0 for
rms 1 and 2 respectively. The rms are bargaining for T x c1 + yT c2
which gives a bargaining surplus of yT c2 . Splitting the bargaining surplus
equally gives the ex-ante licensing agreement payo indicated in the second
line of the upper-left branch on the diagram in exercise (d).

35

Exercise 8.2: AntiCompetitive CrossLicensing (Motta, 2004)

Consider two rms that play the following game. In the rst stage, they jointly decide whether
they want to cross-license their technologies. The technologies are assumed to be perfect
substitutes and are used to produce the same homogenous good. At this stage, if crosslicensing is agreed upon, they also jointly decide the same per-unit of output royalty cL for the
cross-license. In the following stage, they compete in quantities. Assume for simplicity that
the only unit cost, if any, is given by cL . Assume linear demand p = 1 Q, where Q is total
output.
(a) Find each rms equilibrium output and the associated per-rm prot if no cross-licensing
is agreed upon.
When no cross-license is agreed upon, each rm solves
max
qi

i = (1 qi qj )qi .

The reaction functions are given by

qi (qj ) =

1 qj
.
2

In a symmetric equilibrium, each rms output is q N L = 1/3 and the associated per-rm prot is N L = 1/9.
(b) Assuming that cross-licensing is agreed upon, write down the maximization problem of
each rm and nd equilibrium outputs and per-rm prots.
Firm i solves
max
qi

i = (1 qi qj cL )qi + cL qj .

The term cL appears both as cost and as revenue, because each rm has to
pay the other a unit royalty. The reaction functions are
1 qj cL
1 qi cL
and qj (qi ) =
.
2
2
Equilibrium outputs and per-rm prots are,
qi (qj ) =

q L (cL ) =

1 cL
3

and

(1 + 2cL )(1 cL )
,
9
respectively. Note that here is an example where prot is not equal to quantity
squared for all cL .
L (cL ) =

(c) In the rst stage, rms not only decide whether to cross-license or not but also they
determine the level of cL . Find the equilibrium level of the unit royalty.
To nd the equilibrium level of cL , we need to nd the value at which the
function L (cL ) reaches its maximum. Solving
2(1 cL ) (1 + 2cL ) !
d L
=
= 0,
dcL
9
36

we obtain cL = 1/4.
(d) Compute each rms equilibrium output and prot.
The output of each rm is
q L (1/4) =

1 1/4
= 1/4
3

and the perrm prot is

L (1/4) =

(1 + 2(1/4))(1 1/4)
= 1/8.
9

(e) Are the rms going to cross-license their technologies?

The joint output and prot under cross-licensing correspond to the joint prot
maximization outcome, i.e. the monopoly solution. To see this, consider the
monopolists problem:
= (1 Q)Q

= 1 2Q = 0
Q

QM =

1
2

Since total output is given by Q = qi + qj and qi and qj are equal, we see

that under cross licensing the rms do indeed end up producing the monopoly
quantity. Note that the monopoly prot is higher than the sum of Cournot
prots when no cross-license is agreed upon (see (a)).

37

Problem Set 9: Licenses and Litigation

Exercise 9.1: Prot Neutrality in Licensing (Maurer and Scotchmer, 2004)
Consider a situation where a new product is invented. The product must be produced eciently
to reach its full value but in many cases the patentholder may not be necessarily the most
ecient rm to produce it. Assume that the rm faces a convex and positive increasing
marginal costs function denoted by (). If marginal costs are increasing, the average cost of
supply can be lowered by producing in several plants. Furthermore, let C be the set up cost
for each production plant. Thus the cost of producing q units of the product in a single plant
is given by

q

(q) = C +

[
q ]d
q.

Assume linear demand for the proprietary good p(q) = 1 q, where q denotes total output.
(a) Since set up is costly, ecient production requires a nite number of plants. Assume for
simplicity that the rm is able to produce in two plants. Find the total available prot
as a function of total output if each plant covers half of the production. What is the
resulting benchmark output, price and prot in equilibrium?
The total available prot is given by
T = p(q)q 2[q/2],
which can be rewritten as

= (1 q)q 2C 2

q/2

[
q ]d
q.

Solving the maximization problem (use Leibnitz integral rule) leads to

T
!
= 1 2q [q/2] = 0.
q
The prot-maximizing total supply and the resulting price is
1
q = (1 [q /2])
2

and

1
p(q ) = (1 + [q /2]).
2

The associated benchmark prot is T = p(q )q 2[q /2].

(b) Assume that the rm licenses all production to two rms. Each licensee is charged
the same per-unit royalty fee, , so that they face the same marginal cost. Show that
the benchmark output can also be achieved by licensing all production if both licensees
compete in quantities and each supplies q /2. Set the royalty fee to be = q /2.
If both rms face the same marginal cost, they will supply the same output
in equilibrium. Each rm solves
 qi
[
q ]d
q qi
max i = (1 qi qj )qi C
qi

38

and obtains

i
!
= 1 2qi qj [qi ] = 0.
qi

Assuming that qi = qj = q /2 and = q /2, we obtain

1
q = (1 [q /2]),
2
which is the same benchmark output.
(c) Consider now a situation where the patentholder produces in one plant and there is only
one licensee. Is it possible to obtain the benchmark prot-maximizing quantities with a
royalty fee?
Hint: Start by solving the maximization problem of each rm
The licensee maximizes the following prot function
1 = (1 q1 q2 )q1 [q1 ] q1 ,
obtaining

1
q1 (q2 ) = (1 q2 [q1 ] ).
2
The prot function of the patentholder is given by
2 = (1 q1 q2 )q2 [q2 ] + q1 .
After solving the maximization problem the licensor obtains
q2 (q1 ) =

1
(1 q1 [q2 ]).
2

If > 0, the equilibrium does not satisfy q1 = q2 , since

q2 + [q2 ] = q1 + + [q1 ]
If the patentholder licenses only to one rm at a royalty fee , the eective
marginal cost of the licensee is higher than that of the licensor, hence in
equilibrium the licensee produces less and production is inecient. In this
situation the benchmark prot can not be reached.

39

Exercise 9.2: Litigation (Scotchmer, 2004)

When a product patent is infringed the court can mete out damages. The infringer must
either pay the patentholder his lost prot or return his unjust enrichment. These remedies
serve two purposes: compensate the infringed patentholder and deter infringement. Assume
linear demand for the proprietary good p(Q) = 1 Q and constant marginal cost c. If an
infringer enters the market, both rms compete in quantities.
(a) Find rst the patentholders prot under monopoly M . Then, assuming that both rms
are competing in the market, nd the prot of the patentholder Ip , and the prot of the
infringer (C=competitor) Ic . Show the results in a diagram.
No infringement (Monopoly)
The rm maximizes
M = (1 Q)Q cQ.

max
Q

In equilibrium the output, price and prot are

1
QM = (1 c)
2
1
pM = (1 + c)
2
1
M
= (1 c)2
4

Infringement (Competition)
Each rm maximizes
max
qi

i = (1 qi qj )qi cqi

and obtains

1
qi = qj = (1 c).
3
The equilibrium output, price and total prot are
2
QC = (1 c)
3
1
pC = (1 + 2c)
3
2
C
= (1 c)2
9
The prot of the patentholder and the prot of the infringer are
1
Ip = Ic = (1 c)2
9
If the infringer enters the market, the patentholder loses market share and the
market price decreases. See Figure 7.1 in Scotchmer (2004).

40

(b) Find the patentholders lost prot and the infringers unjust enrichment
The patentholders lost prot would be
M Ip =

5
(1 c)2 .
36

The infringers unjust enrichment would be

1
Ip = (1 c)2 .
9
(c) In the case of punishment, does the patentholder prefer to get back his lost prot or the
unjust enrichment of the infringer?
Because the monopoly prot is larger than the oligopoly prot, it follows that
M > Ip + Ic .
Thus,
M Ip > Ic .
The patentholder prefers the lost-prot rule to the unjust-enrichment rule.
(d) Does the lost-prot penalty deter infringement?
Yes. With the lost-prot rule the infringer would have to pay ( M Ip ).
This is more than the prot he would achieve when infringing (Ic ). The
unjust-enrichment rule might also deter infringement, since the infringer is set
indierent between infringing or not, when he has to disgorge his prot.

41

Problem Set 10: Private-Public Partnership

Exercise 10.1: Private-Public Incentives (Scotchmer, 2004)
In the ideas model, an idea is a pair (v, c), where v represents per-period social value and
c the cost. There are two ways to fund the idea and turn it into an innovation: funding it by
the public sector, or by the private sector through proprietary prices. If the idea is funded by
the public sector, v also represents the per-period consumer surplus with competitive supply
and its discounted social value is (1/r)v. If the idea is funded by the private sector under an
intellectual property regime, the prot available under a patent that lasts for discounted length
T is vT , where is the fraction of per-period value that goes to prot. Assume that v and
c are known to the private sector but not to the public sector.
(a) Which ideas would the public sector like to support? Which ideas would the private
sector like to support?
The public sectors objective is to invest in those ideas for which vr c > 0,
but it cannot identify which ideas they are. The private sector will invest in
those ideas for which vT c > 0.
(b) There are some ideas with a commercial value that is not sucient to cover costs, but
at the same time still would still be worth doing from a social point of view. These
ideas are characterized by the following inequality 1r v > c > vT . In an attempt to
see these ideas implemented the government decides to oer a subsidy s to the private
sector. Show which ideas will be realized? Show the result graphically. Is a subsidy a
good solution?
With a subsidy from the government the private sector will invest in those
ideas for which vT + s > c. The amount of funded ideas will increase with
the subsidy, but there are low-v ideas for which the subsidy should not be
given. The subsidy should not be given to ideas that fall in the lled triangle
on the gure below:
c

v
r

vT + s
vT

s
v

(c) Suppose the government insists that in order to claim the subsidy the private sponsor
must make a matching commitment of funds in some amount m. In other words, the
42

private and the public sponsors jointly contribute m + s and invest in ideas suggested
by the industrial sponsor. If the chosen idea is such that c > s + m, then the private
sponsor must provide the required supplement. If the idea is such that c < s + m, then
the surplus goes to supporting graduate students. Finally, assume for simplicity that the
private sponsor receives vT on the subsidized innovation.
Which ideas are going to be funded by the private sponsor alone (i), by the government
and the industrial sponsor together (ii), and which ideas are not going to be funded at
all (iii)? Show the results graphically.
i) It is always cheaper for the private sector to claim the subsidy for ideas
where c > m and it is always cheaper for the private sector to not claim
the subsidy if c < m. We therefore restrict attention to ideas where
c < m. Further, if the private sector does not claim the subsidy, the
commercial value has to be above the cost, i.e. vT > c. The set of
ideas are marked in light grey in the gure below.
ii) We now restrict attention to ideas where the private sector will claim the
subsidy, i.e. where c > m. We split the analysis in two. First, for ideas
where c > s + m the private sector will only implement ideas for which
the commercial value is larger than the cost minus subsidy, i.e. where
vT > c s. Second, for ideas where m < c < s + m the private sector
will only implement ideas for which the commercial value is larger than
the required supplement m, i.e. where vT > m. This sets a lower limit
m
. The set of ideas are marked in
for the value of an idea given by v = T
dark grey in the gure below.
iii) The remaining ideas are not going to be funded.
A graphical illustration can be found in Scotchmer (2004) gure 8.4:
c

vT + s
vT

s+m
s
m
v

A partnership with matching funds sets incentives to the industrial sponsor to

fund ideas that otherwise would not have been funded and solves the moral
hazard problem.

43

Exercise 10.2: The Government Grant Process (Scotchmer, 2004)

Grants, as opposed to prizes or intellectual property rights, cover researcher expenditure before they are incurred. In Switzerland, the largest governmental sponsor is the Swiss National
Science Foundation (SNSF); it calls for proposals and awards it funds to researchers whose
ideas are promising and worth implementing.
Consider the following discrete-time model. Researchers get ideas for projects with a frequency
n = 1/n, which means a researcher gets ideas every nth period (n 1, 2, ...). A researcher
can implement an idea immediately in each time period, and all ideas have the same value and
cost (v, c). Assume that grants are awarded with certainty. Finally, if a proposal is accepted
for funding the researcher receives c < < v. The timing in the model is illustrated below:
Idea and implementation

Idea and implementation

No idea

No idea

No idea

n1

No idea

No idea

n+1

n+2

(a) Assume that a researcher can always complete all ideas when she chooses to incur the
eort cost c. Find the discounted present value of completing the ideas conceived, for a
researcher with creativity . Suppose that the discount factor is (0, 1).

1
t
Hint: If < 1, the formula for the geometric series is
t=0 = 1 .
To grasp the intuition, we rst calculate the discounted present value for a
researcher with = 13 . The payo from investing in all research ideas is then
given by:
U ()|= 1
3

= ( c) + 0 + 02 + ( c)3 + 04 + 05 + ( c)6 +
= ( c)(1 + 3 + 6 + 9 + ).

Setting = 3 we nd:
U ()|= 1
3

= ( c)(1 + + 2 + 3 + )
=

c
c
=
.
1 1 3

For the general case, dene


1, if t is a time period where the researcher has an idea
1I =
0, otherwise.
The discounted present value for a researcher with productivity is then given
by:
U () =




c
( c)t I = ( c)
nt = ( c)
(n )t =
.
1 n
t=0

t=0

44

t=0

(b) If the researcher is awarded the grant and decides not to incur the cost c, what is the
present value of lost future grants?
The net loss from missing future grants is simply the innite stream of prot
discounted from the time the researcher would have her next idea:
n U = n

c
.
1 n

(c) The researchers net gain if she does not implement the idea is the saved cost c. Under
what condition is the researcher going to perform instead of pocketing the money?
The researcher will perform if
c  n

c
1 n

c  n

. Taking logs and noting that log() < 0, we derive that:

n

log(c) log()
.
log()

Hence, only researchers with low n and thus high productivity can be expected to perform. Further, raising the grant size, , will make more lazy
researchers stay in research. Impatient researchers and researchers for which
costs of implementing projects are high are also seen to be more likely to shirk.

45

Problem Set 11: Strategic Patenting, Patent Pools

and Mergers
Exercise 11.1: Strategic Patenting (Belleamme and Peitz, 2010)
Consider a market where demand is given by P (q) = aq. An incumbent rm has a proprietary
technology with a constant marginal cost of cI (with cI < a). One other rm could enter the
market as a Cournot duopolist, but the technology available to this rm does not allow it to
make any positive prot if it enters. More precisely, the marginal cost corresponding to the
entrants technology, cE , is such that cE  (a + cI )/2 c.
(a) Show that the entrants technology implies the non-positivity of the entrants quantity
at the Cournot-Nash equilibrium.
The incumbent and entrant maximizes
I = (a qI qE )qI cI qI

and E = (a qI qE )qE cE qE

respectfully. The lowest possible value of the entrants marginal cost is cE = c

and, hence, it suces to show that qE  0 for this case. Plugging in cE =
(a + cI )/2 in the entrants prot yields:
a
cI
E = ( qI qE )qE qE .
2
2
We obtain the reaction functions:
qI =

a cI qE
2

and

qE =

a cI 2qI
.
4

Solving for the entrants quantity yields qE = 0.

(b) Suppose now that an alternative technology becomes available with a constant marginal
cost c comprised between cI and c. Specically, assume that a = 10, cI = 6, cE = 8,
and c = 7. Show that, although the incumbent has no incentive to switch to and use
this technology, it has a higher incentive to acquire a patent on it than the entrant has.
To show this, we need to compare the incumbents and the entrants prots in
the situations where either one patents the technology. Denote the situation
in which the incumbent patents by superscript IP . If the entrant patents we
EP IP .
use the superscript EP . We need to show that IIP IEP > E
E
If the incumbent patents: This is equivalent to the initial situation, in
which no alternative technology is available. Hence, the entrant stays out of
IP = 0. The incumbent maximizes monopoly prots
the market and makes E
IP
I = (a qI )qI cI qI . We obtain IIP = 4.
EP = (10q q )q 7q
If the entrant patents: The entrants prot is E
I
E E
E
3qI
E
and the resulting reaction functions are qE = 2 and qI = 4q
.
We
obtain
2

46

the equilibrium quantities qI = 53 , qE = 23 , IEP =

25
9 ,

EP = 4 .
and E
9

It is now straight-forward to obtain that the incumbents and the entrants

4
gains from patenting are 11
9 and 9 , respectively. Hence, the incumbent has
higher incentives to patent the technology even if it will not be used. This
can be seen as strategic patenting and may help to explain why some rms
le for many more patents than they actually intend to use.

47

Exercise 11.2: Patent Pools and Mergers (Belleamme and Peitz, 2010)
Consider a vertical market structure with 2 upstream rms (rms A and B) and 2 downstream
rms (rms a and b). The downstream rms require the input of each of the upstream rms,
who demand linear royalties (raA , rbA , raB , rbB ) charged for each unit the respective downstream
rm sells. Downstream rms face the inverse demand P (Q) = 1 Q; where Q = qa + qb .
Assume that the royalties accruing to the upstream rms are the only costs that the downstream
rms face and all costs of the upstream rms are sunk.
(a) Draw the market structure and indicate each rms prots.

Firm A

Firm B

= r a qa + r b qb

= r a qa + r b qb

r b qb

r a qa

r b qb

r a qa

Firm a

Firm b

a = (1 (qa + qb ) ra rb )qa

b = (1 (qa + qb ) rb rb )qb

(q)qa

(q)qb

Consumers
(q) = 1 (qa + qb )

(b) Solve for the symmetric subgame-perfect Nash equilibrium in which the upstream rms
set non-discriminatory royalties (rI = riI = rjI ) in the rst stage and downstream rms
engage in Cournot-competition in the second stage.
The downstream interactions are of standard Cournot-type. Downstream rms
individually maximize. In particular, i = qi (1 (qi + qj ) r A r B ). One
obtains the reaction functions
qi (qj ) =

1 qj rA rB
.
2

Therefore, in equilibrium, the downstream rms each choose quantity

qi =

1 rA rB
.
3

48

Anticipating this, the upstream rms maximize

I = rI (Q(rI , rJ )) = rI (2

1 rI rJ
),
3

which yields the reaction functions

1 rJ
.
2

rI (rJ ) =
We therefore obtain rA = rB =

1
3

and total output Q = 29 .

(c) Now assume that rms A and a merge (vertical merger) and maximize joint prots.
Solve for a subgame-perfect Nash equilibrium in which the upstream rms set royalties
in the rst stage and downstream rms engage in Cournot-competition in the second
stage. How does the merger aect total royalties charged and quantities sold?
Denoting the prots of the merged rm as A , we get the following prot
functions:11
B = rB (qa + qb )
b = qb (1 (qa + qb ) rA rB )
A = rA qb + qa (1 (qa + qb ) rB ).
While rA does not aect the output decision of downstream rm a anymore,
it does still aect the choice of rm b (raising rivals cost eect). On the
other hand, as rm a increases qa , this does not only lower the price in the
downstream market, it also lowers the amount of the good rm b produces.
In a Cournot equilibrium, rm a will not take this into account, as it takes the
amount produced by b as given (as opposed to, say, the Stackelberg case).
The two rms reaction functions are:
qb (qa ) =

1 qa rA rB
2

qa (qb ) =

and

1 qb rB
.
2

Solving these yields the equilibrium production levels

qa =

1 + rA rB
3

and

qb =

1 2rA rB
.
3

Anticipating this, upstream rm B maximizes

B = rB (

2 rA 2rB
)
3

which yields the reaction function

rB (rA ) =

2 rA
.
4

We focus on the internal solution; Alternatively rm A sets rA so high to force rm b out of the market
and therefore anticipates the standard monopoly outcome in the second stage.
11

49

Firm A maximizes
 





1 + rA rB
2 2rB rA
1 2rA rB
+
1
rB ,
A = rA
3
3
3
which yields the reaction function
rA (rB ) =

1 rB
.
2

Therefore, in equilibrium, the royalty rates are rA = 2/7 and rB = 3/7. The
total quantity produced downstream is

, rB
) + qb (rA
, rB
)=
Q = qa (rA

2
2 rA 2rB
= .
3
7

Note that while the total royalty has increased, downstream production still
increases.
(d) Starting from the original (separate) setup, now assume that rms A and B merge (horizontal merger) and maximize joint prots. Solve for a subgame-perfect Nash equilibrium
in which the upstream rm(s) set one nondiscriminatory royalties (rM = raM = rbM )
in the rst stage and downstream rms engage in Cournot-competition in the second
stage. How does the merger aect total royalties charged and quantities sold? What is
the overall welfare implication of the merger compared to question (b)?
Now there is one upstream monopolist charging rM . The downstream Cournot
equilibrium quantities (as in (b)) are qi = qj = 1r3 M where rM = rA + rB .


M)
, which yields
Therefore, the upstream rm maximizes M = rM 2(1r
3
=
the royalty rate rM

1
2

and total quantity QM = 13 .

Since the merged upstream rm can always set rM = rA + rB it can as a

minimum make the same prot as in (b). Therefore, the upstream rm is
at least as good o as before. The intermediate rms are also better o as
they face lower marginal costs. Lastly, since quantities produced are higher
consumers are also better o.

50

Problem Set 12: Diusion

Exercise 12.1: Diusion (Tirole, 1988)
Consider an industry with an incumbent and a potential entrant. The incumbent makes ow
prot m
0 before adopting a process innovation (monopoly setting). If only the entrant has
adopted, the respective prots are d1 and d2 (asymmetric duopoly). If only the incumbent
m
has adopted, it makes ow prot m
1 > 0 (monopoly setting). If both rms have adopted,
each makes a ow prot of d (symmetric duopoly). Suppose that d1 + d2  m
1 and
d1 < d < d2 . Time is continuous, and the rate of interest ir r. The cost of adoption, C(t),
is decreasing and convex, is high at date 0 (no one wants to adopt initially), and eventually
becomes low (both rms end up adopting).
(a) Interpret the assumption about the ow prots.
The assumption d1 + d2  m
1 requires that aggregate prots in a duopoly
are lower than in a monopoly setting (when taking the inecient rm out).
is the eciency eect. Once the new technology is in the market, the prot
obtained by an adopter incumbent is lower that the aggregate prot obtained
jointly by a passive incumbent and an adopter entrant.
The second assumption, d1 < d < d2 , suggests that the new technology is
superior to the incumbents initial technology.
(b) Show that the entrant is a faster second in the sense that it reacts earlier to preemption
than the incumbent.
Given the competitor has innovated, the optimal date for adopting can be
derived as follows:
The incumbent solves:

max
t


d d1
C(t) ert .
r

From the rst order condition, we obtain

rC(T1F ) + |C  (T1F )| = d d1 .
The entrant solves:


max
t


d
C(t) ert .
r

From the rst order condition, we obtain

rC(T2F ) + |C  (T2F )| = d .
To show that the entrant is a faster second, we use the results of the
maximization problems. Since d > d d1 , we have that
rC(T2F ) + |C  (T2F )| > rC(T1F ) + |C  (T1F )|.
51

Because cost of adopting are decreasing and convex, we nally know that
T2F < T1F . The entrant will follow rst, owing to the fact that the incumbent
already makes a prot before adopting the new technology.

52

Exercise 12.2: Open Source Software (Belleamme and Peitz, 2010)

Consider a market with n software rms competing in quantities. Each rm incurs a constant
marginal cost equal to ci and produces a dierentiated product in quantities q
i , sold at price
pi . Each rm faces linear inverse demand given by pi (qi , qi ) = a qi j=i qj where
[0, 1] is the inverse measure of product dierentiation.
(a) Write down the rms problem and nd the best response function and equilibrium
production level.
The problem of a typical rm can be written
max i = max (a qi
qi

qi

qj ci )qi .

j=i

The FOC gives us rm is reaction function

qi (qi ) =


1
(a
qj ci ).
2
j=i

Summing over all i gives the total quantity in the Nash equilibrium
Q =


i

where C =

qi =

1
(na (n 1)Q C)
2

Q =

na C
,
2 + (n 1)

i ci .

By denition it is seen that



qj = Q qi and C =
cj + ci .
j=i

j=i

Inserting the three results above into rm is reaction function gives us the
equilibrium quantity

a(2 ) ci (2 + (n 2)) + j=i cj

.
qi =
(2 + (n 1))(2 )
It can be seen from rm is prot and best response function above that
i = (qi )2 .
(b) In the pre-innovation stage, all rms use the technology and produce at marginal cost
ci = c > 0. Suppose now that rm 1 has developed a software innovation that has the
eect of decreasing its marginal cost to c1 = c x with 0 < x < c. Find the prot of
rm 1 when the innovation is patented or kept secret.
Plugging the marginal costs into the result above gives the results:

1secret

a(2 ) (c x)(2 + (n 2)) + (n 1)c

(2 + (n 1))(2 )

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2

(c) Alternatively, rm 1 can choose to disclose the source code of its innovation. Disclosure
will entail two contrasting eects. On the one hand, the quality of the software will be
enhanced thanks to the eorts of open source developers. We model this positive eect
by assuming that rm 1s cost will be reduced further after disclosure: c1 = c x,
with 1 < < c/x as a measure of the contribution from the open source community.
On the other hand, disclosure also means that rm 1s competitors will have access to
the innovation as well. We assume that after disclosure, the other rms marginal cost
becomes cj = c x, where 0 < < 1 measures the generality of rm 1s software
innovation (if = 0, the software is completely specic to rm 1s production process;
if = 1, the software is completely general and yields identical benets to all rms).
Find the prot of rm 1 when the rm discloses the source code under open source.
Inserting the marginal costs under disclosure gives the results:

1disclose

a(2 ) (c x)(2 + (n 2)) + (n 1)(c x)

(2 + (n 1))(2 )

2

(d) Find the condition under which the rm disclose under open source and discuss the
eects of (i) competition, (ii) the generality of the software innovation, and (iii) the
contribution from the open source community.
The innovative rm will release the source code if prot is larger by doing so
1disclose  1secret

2 + (n 2)
.
2 + (n 2) (n 1)

It is now seen that higher likelihood of source code release under open source
goes along with
i) lower competition on the product market (lower or lower n),
ii) higher specicity of the software for the innovating rm (lower ), or
iii) larger contributions from the open source community (larger ).

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