Innovative Applications of O.R.
Licensing and information disclosure under asymmetric information

https://doi.org/10.1016/j.ejor.2019.01.005Get rights and content

Highlights

  • We study a license contract in the presence of information asymmetry and competition.

  • The more valuable technology is, the more information the innovator discloses.

  • This finding is consistent with empirical evidence on firms’ disclosure strategy.

  • Despite the disclosure, innovators invest earlier under asymmetric information.

  • Total firm values may increase due to the diffusion of knowledge.

Abstract

We examine a license contract in a vertically separated market in the presence of a competitor’s challenge and information asymmetry. When technology’s value is not observable, innovators with more valuable technology disclose their private information to receive a fair payment despite a rival’s earlier challenge, whereas the owner of less valuable technology reveals nothing. We show that the more valuable technology is and the less bargaining power the innovator has, the more information the innovator discloses. This finding is consistent with empirical evidence on inventors’ disclosure strategy after the American Inventors Protection Act (AIPA). Furthermore, we show that despite the information disclosure, innovators make R&D investment earlier than they would have under symmetric information. This is in contrast with conventional wisdom that the need to disclose complementary information may retard innovation, and can be explained by the interaction between the decisions of investment timing and information disclosure. Though the leading innovator suffers losses from information asymmetry, the total value of the firms in the market may increase due to the diffusion of knowledge.

Introduction

A patent is the right to monopolize technologies or products, granted by the government, provided they are sufficiently novel compared to those that exist. Despite the maturity specified in the law,1 many patents lose their monopolistic position in the market for various reasons; some are invalidated by court rulings over infringement, while others become obsolete after the invention of more advanced technologies. In this sense, the effective maturity of patent rights differs from the nominal one stated in the law, and is directly linked to the novelty of the technologies for which patents are granted. In most cases, true novelty of patented technologies is hardly known to other parties; not only do innovators not want to disclose their private information on the invention but also it is costly to make others believe. This makes it harder for both inventors and technologies’ users to agree on the royalties.

In this paper, we investigate a license contract of a vertically separated market in the presence of asymmetric information and competition. An upstream firm wants to conclude a license contract for its patented technology with a downstream firm, but a follower can challenge the technology at some point, and the downstream firm does not know how long the monopoly of the patented technology will last. Upon challenge, the patent holder files a lawsuit over infringement, and the court’s ruling is based on the technology’s true novelty. If the leader wins the trial, it maintains the monopolistic position in the market, but it can lose the case and start competing with the follower. In this sense, the probability that the patentee wins the trial is directly linked to the value of the patented technology, which only the innovator knows.

First, we show that an innovator with more valuable technology voluntarily discloses its private information about the invention despite the rival’s earlier challenge, whereas the one with less valuable technology reveals nothing. This result is in line with theoretical analyses of Gick (2008) and Anton, Yao, 2002, Anton, Yao, 2008. The former, which examined signaling via patent disclosure, lacked an explanation of how exactly the disclosure incurs costs to the innovators, and the latter studied the sales of idea in the presence of downstream competition based on a static model. In contrast, we clarify the cost of information disclosure by incorporating the follower’s challenge and examine the interaction between the decisions of information disclosure and investment timing based on a continuous-time dynamic model. This finding is also consistent with empirical evidence from Graham and Hegde (2015), who investigate inventors’ disclosure strategy before and after the American Inventors Protection Act (AIPA), which requires U.S. patent applications to be made public within 18 months from the filing date, except for those without a parallel foreign filing. They show that a surprisingly large portion of applicants who could have opted out of the 18-month publication enforcement actually chose pre-grant disclosure over pre-grant secrecy.

Furthermore, we show that innovators overinvest in R&D under asymmetric information. Given the follower’s earlier challenge induced by information disclosure, the leader makes an R&D investment earlier than it would have under symmetric information, not only because it can raise more revenue before the rival challenges but also because earlier investment lowers the amount of information disclosure for more valuable technology. This result is in contrast to the conventional wisdom that the need to disclose complementary information such as pre-grant publication will retard innovation. Aoki and Spiegel (2009) examine the impact of pre-grant publication in the presence of cumulative innovation and claim that it will lead to fewer inventions. Gans, Hsu, and Stern (2008) focus on the impact of uncertainty during patent pendency, and show that the hazard rate of achieving a license significantly increases after patents are granted. We analyze the interaction between the decisions of information disclosure and investment timing from the dynamics perspective, and show that the need to disclose private information puts the timing of innovation forward.

Regarding the extent of information disclosure, we find that the more valuable the technology is and the less bargaining power the innovator has, the more private information its owner discloses. This result is in line with theoretical analysis by Anton, Yao, 2002, Anton, Yao, 2008 and empirical evidence from Graham and Hegde (2015). The former investigates the sale of ideas with downstream competition and showed that the amount of disclosure increases with the idea’s value. The latter finds that the probability of choosing pre-grant secrecy over pre-grant publication decreases with the value of patents, especially for small inventors. Our model also shows that the stronger the follower’s challenge is, the more private information the leader discloses. The follower challenges earlier when its technology substitutes the leader’s one to a larger extent. Given the imminent challenge, a leader with less valuable technology has more incentive to pretend that it has more valuable one. Thus, the owner of more innovative technology has to disclose more information to separate itself from the owner of less valuable one, which worsens the leader’s firm value.

Lastly, we show that even though the leading innovator suffers losses from information disclosure, the total value of the firms in the market may increase under asymmetric information due to the diffusion of knowledge. The follower can refer to the disclosed information for its own R&D and save costs for duplicative R&D, which is socially beneficial. As a whole, the benefits from R&D spillover can dominate the leader’s losses. This result supports the requirement of pre-grant publication upon patent application. Cohen, Goto, Nagata, Nelson, and Walsh (2002) conducted national surveys in the U.S. and Japan, and found that though innovators’ appropriability is lower, R&D spillovers are significantly greater in Japan,2 where the patent system focuses more on the diffusion of technology.3 This suggests that a diffusion-oriented patent system can benefit society as a whole.

Among the many papers devoted to information disclosure in technology market, a series of works by Anton and Yao represents a major contribution. Anton, Yao, 2002, Anton, Yao, 2008 study the sales of idea in the presence of incomplete information regarding the idea’s value and downstream competition. Anton, Yao, 2003, Anton, Yao, 2004 examine duopoly competition with asymmetric information on the cost structure. In terms of the degree of disclosure, Anton, Yao, 2002, Anton, Yao, 2008 show that it increases in the ideas’ value, whereas Anton, Yao, 2003, Anton, Yao, 2004 find that inventors with better technology discloses less. The difference comes from the incentive to disclose described in each model. Anton, Yao, 2002, Anton, Yao, 2008 suppose that the inventor reveals the idea to receive a fair payment from the buyer, while in Anton, Yao, 2003, Anton, Yao, 2004, the leader discloses private information to affect the follower’s capacity decision. The motive to disclose information in our model is identical to that in the former, and the result is also in line with theirs: the more valuable the technology is, the more the innovator discloses information. Yet, we elucidate the dynamics perspective of technology market by incorporating the follower’s challenge and examine the interaction between the decisions of information disclosure and investment timing, whereas Anton, Yao, 2002, Anton, Yao, 2008 focus on the sale of ideas based on a static model.

As mentioned above, there are different motives to disclose information for different market structures. Harhoff (1996) shows that a supplier transfers knowledge to downstream firms so that they demand more intermediate goods from the supplier. Harhoff, Henkel, and Hippel (2003) consider a manufacturer that decides whether to improve a product or not and offers it to two user firms, and investigate why user firms reveal their proprietary innovation. Bhattacharya and Ritter (1983) illustrate innovators’ signaling via disclosure to reduce the cost of capital in a competitive R&D race. Fraja (1993) examines a patent race between two firms with spillover and showed that they disclose their knowledge to maximize the probability of discovery. Baker and Mezzetti (2005) argue that firms disclose their information to extend the patent race by making it difficult for their rivals to patent. Ponce (2011) analyzes the tradeoff of knowledge disclosure by patents and find that it reduces the rival’s R&D costs, yet also lowers the probability that the rival receives a patent.

Information disclosure has a huge impact on the dynamics of innovation, and for that reason, AIPA is considered to be one of the most significant changes in the U.S. patent system. Many economists show concern that it will stifle innovation by disincentivizing innovators, especially small inventors; 26 Nobel laureates wrote a letter to the U.S. Senate warning of the possible damage it can bring to the innovation market. In addition to Graham and Hegde (2015), there are other empirical analyses of its impact on the technology market. For instance, Hegde and Luo (2018) showed that licensing delays fell by about 10 months on average after AIPA’s enactment. Johnson and Popp (2003) find that it is most likely to affect major inventions because they take longer to go through the application and examination process.

A great deal of studies investigate a license contract under asymmetric information. Gallini and Wright (1990) assume that a licensor has private information on the value of new technology and study how signaling via the terms of a contract works. Beggs (1992) also examines how license terms are determined, but supposes that a licensee, not a licensor, has better information about the value of technology. Schmitz (2002) studies an inventor’s nonexclusive license contract with two downstream firms that have private information about their own profitability. Martimort, Poudou, and Sand-Zantman (2010) presume bilateral asymmetric information and introduce downstream competition by allowing the upstream firm to release its ideas to the licensee’s rival if the downstream firm steals the idea and runs its own business without a license contract.

The remainder of this paper is organized as follows. We describe the setup of the model in Section 2.1 and analyze the problem under symmetric information as a benchmark model in Section 2.2. Based on the arguments from the benchmark model, we proceed to the main model, which incorporates information asymmetry about a technology’s value in Section 2.3. We dedicate Section 3 to comparative statics based on numerical analysis with the parameters given in Section 3.1. 3.2 Asymmetry in technology’s novelty, 3.3 Firms’ bargaining power, and 3.4 discuss the effects of asymmetry in technologies’ novelty, firms’ bargaining power, and the degree of technological progress, respectively. Section 4 provides a brief summary of the paper.

Section snippets

Setup

Suppose there is an upstream leader that can develop new technology and acquire a patent at a lump-sum cost cL. A product based on this technology yields revenue flow πMXt with a constant πM and a demand shock Xt given by a one-dimensional geometric Brownian motion as follows:dXt=μXtdt+σXtdWt,where μ and σ are positive constants and (Wt)t ≥ 0 is a standard Brownian motion on a filtered probability space (Ω,F,F:=(Ft)t0,P) satisfying the usual conditions. The discount rate is given by a constant

Parameters

We adopt the following parameters as a benchmark case for comparative statics:r=0.05,μ=0.02,σ=0.2,pg=2/3,pb=1/3,β=0.5,cL=cF=2,πM=πD=1,πDF=πD,x=0.1.Type g technology is assumed to be twice as novel as type b in that it is twice more likely to be found valid by a court’s ruling. For simplicity, the upstream leader and follower’s investment costs are set equal. The bargaining power of the upstream and downstream firms are set equal as well. We assume that the market size is irrelevant to the

Conclusion

In this paper, we examined a license contract in a vertically separated market in the presence of a rival’s challenge and information asymmetry regarding technologies’ values. The innovator with more valuable technology voluntarily discloses its private information about the invention to separate itself from the one with less valuable technology so that it can raise a fair royalty payment. The disclosed information, however, is diffused to the follower as well, and leads to an earlier challenge

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    This work was supported by the JSPS KAKENHI (grant number 17K13728).

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