Strategic technology licensing in a supply chain

Highlights

• We consider a two-player supply chain investing in a new technology.

• Players share the investment cost in research and development.

• The retailer can license the technology to a competitor in the same product market.

• We characterize the conditions under which licensing is part of an equilibrium.

• We look at impact of research and development and market uncertainty on strategies.

Abstract

This paper deals with R&D investment and technology licensing in a supply chain formed of an original equipment manufacturer (OEM) and a contract manufacturer (CM). The R&D is conducted by the CM and the OEM agrees to pay a share of the cost. At the R&D stage, we assume that there are some uncertainties both in terms of performance of the developed technology and market uncertainties. These uncertainties are resolved in the sales stage, as technology matures and information about consumers’ preferences become available. Further, the OEM can license the technology to a third party and share the revenues with the CM. We characterize equilibrium pricing and licensing strategies in two scenarios, namely, the licensing decision is made before or after the uncertainties are resolved. A comparison of the two equilibria indicates that the OEM is indifferent between making the licensing decision in the first or the second stage in most cases. But when the market potential, competition intensity, royalty rate and revenue sharing rate are moderate, there exists a small region in the parameter space where the OEM prefers to make the licensing decision in Stage 2. Interestingly, we obtain that for a large region of the parameter space, the two partners have the same preferences in terms of licensing. It is also found that different probability distribution of stochastic technology efficiency results in different licensing strategies.

Introduction

Cooperation in research and development (R&D) is popular among technology-intensive firms pursuing time and cost reduction, better product design, and higher quality objectives (Albino, Carbonara, & Giannoccaro, 2007). Coordinated investment in R&D is often preferred to competitive investment because: (i) it achieves higher economics of scale and scope; (ii) it reduces risk and wasteful duplication of R&D efforts; and (iii) it leads to higher total investments, and therefore higher knowledge, as appropriability and free riding are no more an issue (Ge, Hu, 2008, Harabi, 2002).

Cooperation in R&D between firms can be horizontal or vertical. In the former, companies competing in the same product market coordinate their R&D efforts by, e.g., jointly investing in a research laboratory; see the seminal papers by d’Aspremont and Jacquemin (1988) and Kamien, Muller, and Zang (1992). Vertical cooperation refers to firms belonging to a supply chain, e.g., an upstream company and a downstream firm that collaborate in R&D to realize a collectively better outcome. For instance, Dell helped in 2002 its supplier Lexmark to enhance its printer technology with an innovative Dell-developed cartridge replenishment software, which eventually benefited both firms (Bhaskaran & Krishnan, 2009). Toyota Motor Co. Ltd has been cooperating with its suppliers to improve product performance since 1970.¹ Kisiel (2007) mentions that auto manufacturers have also involved suppliers during the production process, which allowed early detection of problems and the use of better components. Vonortas (1997) found that vertical cooperation dominated other types of cooperation in the US during the period 1985–1995, a result also obtained by Arranz and de Arroyabe (2008).

In this paper, a downstream firm (an original equipment manufacturer, OEM) pays part of the R&D investment cost incurred by an upstream firm (a contract manufacturer, CM) to develop a new technology or a new product. This cost-sharing mechanism is in line with what has been observed empirically. For instance, General Motors Corporation provides an annual budget of 200–400 million dollars for its Six Sigma Program, with a significant portion of which being dedicated to improve its suppliers’ component quality (Snee & Hoerl, 2003).

Additionally to R&D cooperation, we assume that the OEM can license the new technology and share the revenues with the CM. Technology licensing means that an organization sells the rights to use its technology in the form of patents, processes and technical know-how to another firm for payment of royalties and/or other compensation (McDonald & Leahey, 1985). Technology licensing has for long been viewed by most high-tech enterprises as a quick and effective means for improving technology and innovation development (Benassi, Di Minin, 2009, Fosfuri, 2006, Lichtenthaler, 2011, Zhao, Chen, Hong, et al., 2014). Arora, Fosfuri, and Gambardella (2004) reports that over 15,000 licensing transactions in technology occurred worldwide already in the period 1985–1997 with a total value of over $320 billion. Technology licensing yields considerable additional revenues to firms, see, e.g., Arora, Fosfuri, and Rø nde (2013); Kim and Vonortas (2006); Lichtenthaler (2011); Zhao et al. (2014). For instance, IBM, Texas Instruments and Dow Chemical are known to collect hundreds of millions of dollars in annual licensing revenues (Arora, Fosfuri, Rø nde, 2013, Lichtenthaler, 2011). It also yields non-monetary benefits such as enabling the licensor to establish industry standards or enter new markets (Gambardella, Giuri, Luzzi, 2007, Lichtenthaler, 2011). However, there may be a negative side to licensing as licensees can develop products that end up competing with the licensor’s products (Avagyan, Esteban-Bravo, Vidal-Sanz, 2014, Bagchi, Mukherjee, 2014, Erkal, Minehart, 2014, Fosfuri, 2006, Kim, 2009). To illustrate, the company RCA that once licensed its color TV technology to a number of Japanese companies for originally exclusive exploitation in Japan ended up facing competition in the U.S. market from these firms that quickly assimilated RCA’s technology (Hill, Hwang, & Kim, 1990). Consequently, the decision of licensing involves a trade-off between the revenues from licensing fees and the potential losses in sales revenues due to the competition from the licensee. Moreover, there is a dense literature that dealt with the design of licensing contracts, that is, the determination of fixed fees, royalties, and also about the coexistence of royalties and fixed fees; see, e.g., Bagchi and Mukherjee (2014); Rostoker (1984); Savva and Taneri (2014); Zhao et al. (2014). This work investigates the OEM’s licensing strategy based on the royalty contract.

Rewards from technology investment are far from being fully predictable (Bhaskaran, Krishnan, 2009, Ma, Grubler, Nakamori, 2009). In the R&D stage, the firm cannot be sure to fully succeed in effectively designing and efficiently manufacturing new products. On the top of this technology (or performance) uncertainty, the firm faces market uncertainty as, at least initially, it does not have reliable data about consumer’s preference and demand (Bacon, Beckman, Mowery, et al., 1994, Bhattacharya, Krishnan, Mahajan, 1998). These uncertainties, called as technology efficiency uncertainty for short, are resolved in the sales stage as the firm has access to more accurate information and the technology and market mature in this stage. This two-stage structure has also been adopted in, e.g., Xiao and Xu (2012) and Ge, Hu, and Xia (2014), however assuming away the above mentioned uncertainties and retaining different licensing and pricing contracts.

Overall, as for the high-tech industries, technology licensing brings about additional licensing revenue on one hand, but it also aggravates competition from the licensees. Thus, technology licensing is a strategic decision for the firm. In conjunction with the fact that technology and market uncertainties exist in the initial stage but are resolved in the second stage, the timing of the licensing decision-making is another issue worth studying. The timing of R&D collaboration decision has been of interest to practitioners and scholars, but most contributions, apart from Allain, Henry, and Kyle (2015), are concerned by investment timing (Harrison, Sunar, 2015, Perdikaki, Kostamis, Swaminathan, 2016) and licensing timing (Crama, De Reyck, & Taneri, 2016). We enlarge the focus of this literature by attempting to respond to the following research questions:

• What is the optimal timing for the OEM to make the licensing decision, and what is the optimal licensing strategy?

• How does technology efficiency uncertainty impact the licensing strategy as well as investment and pricing decisions?

• Under what conditions, licensing is a win-win situation for both channel members?

To address these questions, we consider a two-echelon supply chain playing a two-stage game, where an OEM and a CM jointly conduct technology investment to expand their market. The OEM makes the licensing decision and controls the share it pays of the CM’s investment cost in R&D and its margin. The CM decides the investment level in R&D and its wholesale margin. Two scenarios are considered. In the first scenario, the licensing decision is made in the R&D stage, and therefore we must account for both technology and market uncertainties. In the second scenario, we suppose that the OEM can delay its licensing decision to the sales stage when the uncertainties are already resolved.

By determining and contrasting the strategies and outcomes in the two scenarios, we obtain the following insights: (1) In most cases, the OEM is indifferent between making the licensing decision in the first or the second stage. But when the market potential, competition intensity, royalty rate and revenue sharing rate are moderate, there exists a small region in the parameter space where the OEM prefers to make the licensing decision in Stage 2. Further, there also exist some parameter regions where making the licensing decision in Stage 1 is preferred. (2) If the uncertainty, or the technology competition intensity, or market potential is high, then the OEM does not license the technology. However, it does if its share in the licensing revenues, or royalty rate is high. (3) Technology efficiency uncertainty improves technology investment, expected retail margin and profits for both players, but has a non-monotonic impact in terms of investment sharing rate. (4) If the licensing option is made in the second stage, then no licensing will occur if the technology efficiency is high, and the reverse if it is low. (5) Different probability distributions of the stochastic technology efficiency may lead to different technology licensing strategies. Finally, we obtain that in a large region in the parameter space, the optimal licensing strategy is profit improving for both players.

The contribution of this paper is twofold. First, we propose a model to deal with licensing issues, including licensing strategy and timing of decision-making in the presence of uncertainties, which have been ignored in the licensing literature. We believe that our approach fills a gap in the research on technology licensing. Second, the theoretical results provide guidance for firms to make licensing decision, and the sensitivity analysis gives them hints on how to adjust their strategies in different market environments.

The rest of the paper is organized as follows. Section 2 describes the model. In Section 3, we derive the equilibria in the two scenarios and we compare them in Section 4. This work is extended in Section 5 and concluded in Section 6.