Patent licensing for signaling the cost-reduction innovation: The case of the insider innovator

We analyze the patent licensing contracts offered by an insider innovator that has private information about the quality of innovation that can be transferred to two downstream firms. When information is complete, the first-best choice is a pure-royalty contract which is accepted by both firms (i.e., is nonexclusive). When information is incomplete, however, no nonexclusive contract can be supported as a separating equilibrium; it can only be the case where the innovator sells an exclusive contract to only one firm or a nonlicensing contract where no license is sold. In particular, when the gap in the innovation between the efficient and inefficient type is sufficiently small, there does not exist any separating equilibrium. It is sharply different from the case of an outsider innovation, in which a separating equilibrium always exists.