Licensing option to reduce rent extraction by the input supplier

Abstract

It is well known that if the final goods producers adopt new technologies, the input suppliers with market power can extract more rent from the final goods producers by increasing the input prices. Higher rent extraction by the input supplier neither allows the licenser of the new technology to earn large profit nor helps welfare to increase much. In a model with an outside innovator (the licenser), a final good producer (the licensee) and an input supplier, we offer a new perspective to the literature by considering a licensing option, which is often observed in the business world, but ignored in the literature. We show that the licensing option offered by the outside innovator can prevent rent extraction by the input supplier. The innovator's profit and social welfare are higher under licensing option compared to a standard licensing contract with no option.