Optimal Licensing Policy under Vertical Product Differentiation

• Author: Xuan Nguyen,Pasquale Sgro,Munirul Nabin
• DOI: http://doi.org/10.1111/rode.12270
• Date: 01 August 2017
• Published date: 01 August 2017

Optimal Licensing Policy under Vertical Product

Differentiation

Xuan Nguyen, Pasquale Sgro, and Munirul Nabin*

Abstract

This paper explores a vertical product differentiation model with a licensing arrangement between a

multinational firm with superior technology and a domestic firm with obsolete technology. We find that a

subsidy provided by the domestic country’s government to the domestic firm to assist with the licensing

arrangement is welfare enhancing for the domestic country. Furthermore, both the multinational firm and

the domestic country are better off under royalty than under fixed fee licensing. These findings stand in

contrast to earlier results in the literature.

1. Introduction

Licensing between a multinational firm and a domestic competitor is popular in

various industries in many countries. By providing its superior knowledge and

expertise to the domestic firm through a licensing arrangement, the multinational

firm can extract a higher level of rents in the form of the enhanced benefits to the

domestic firm as a result of using the multinational firm’s advanced technology to

produce products of higher quality.

1

For instance, during the 1980s, a number of

Chinese automakers undertook international licencing to obtain access to the

advanced technologies of US and Japanese car manufacturers (Vause, 1988;

Gallagher, 2003).

2

By doing so, the Chinese automakers could produce cars of

higher quality. Indeed, there has been an increasing trend of international

technology licensing in China. According to the World Development Indicators,

between 1998 and 2009, international licensing fee payments by Chinese firms had

an annual growth rate of over 34%.

3

In many cases that involve international licensing, which enhances domestic

product quality, the domestic government plays an active role in driving the behavior

of domestic firms. In the case of the Chinese automobile industry, in 1987, the

government established the National Automotive Industry Federation to help local

automakers to “digest and absorb imported technology” (Vause, 1988). Similarly, in

the pharmaceutical product market, in 2007, the Thai and Brazilian governments

both requested some domestic firms to undertake international licensing to improve

the quality of AIDS drug medicines they produce (Bond and Saggi, 2012).

Despite the fact that the burgeoning trend of technology licensing, including

licensing between competing firms from different countries, has been an important

*Sgro (Corresponding author), Nguyen and Nabin: Department of Economics, Faculty of Business and

Law, Deakin University, Geelong, Victoria, Australia. Tel: +61-3-9244-5245; Fax: +61-3-9244-5533; E-

mail: pasquale.sgro@deakin.edu.au. The authors thank two anonymous referees, Richard Baldwin, Taiji

Furusawa, Arghya Ghosh, Hong Hwang, Jota Ishikawa, Hodaka Morita, Chen-Hau Peng, Martin

Richardson and participants at Hitotsubashi-UNSW Conference on International Trade & FDI 2011 and

at the National Taiwan University seminar on 28 January 2011 for useful comments.

Review of Development Economics, 21(3), 497–510, 2017

DOI:10.1111/rode.12270

©2016 John Wiley & Sons Ltd