The transformations that occurred at General Electric (GE) in the late 1990s illustrate the importance of quality-improving innovations. Jack Welch launched two company-wide initiatives aimed at increasing the company’s growth. The first was a drive to boost quality. The second represented an effort to capitalize on the company’s most valuable assets. Welch realized that for the company to fully appropriate the potential rents associated with its core industrial strengths in businesses as far afield as health care, aircraft engines, and utilities, GE should consider alternative uses for its complementary products or services. As a result, for instance, GE Medical Systems signed exclusive multi-year service deals with big hospital chains which involve servicing rival manufacturers’ medical equipment; and GE Power Systems is managing power plants for independent power producers.
In this article, Luís Almeida Costa (Professor of Strategy at Universidade Nova de Lisboa, Portugal, and Visiting Professor at INSEAD) and Ingemar Dierickx (Professor of Strategy and Management at INSEAD) study firms’ incentives to license quality-improving innovations comparing independent pricing, bundling, licensing, and licensing plus bundling. Clearly, when the innovating firm has a competitive disadvantage in the production of the original product, it may have the incentive to license the innovation exclusively to the most efficient producer. An exclusive license is one in which the right to use the innovation is granted to the licensee to the exclusion of all the other firms, including the innovating firm. Such a licensing contract may allow the licensee to monopolize the production of the basic product and the innovation, increasing profits by inducing coordinated pricing of both products.
A common problem with this arrangement is that contractual language does not necessarily guarantee that the license will effectively be exclusive. The practical difficulty is that the licensor may be able to invent around this restriction.
The authors propose two solutions to the commitment problem faced by the innovating firm. One is a bundling and licensing strategy, wherein the innovative firm signs off the innovation to a producing firm and then also sells the product and the innovation together.
The authors show that, when exclusive licensing is not possible, licensing and bundling may be complementary strategies. Even if the innovating firm does not have the incentive either to license or to bundle, it may still have the incentive to follow a licensing plus bundling strategy. Bundling provides a mechanism for the innovating firm to credibly commit to compete less aggressively after licensing the quality-improving innovation to the most efficient competitor. By choosing a bundling strategy, the innovating firm accepts a disadvantage in the production of the enhanced product (composed of one unit of the basic product and one unit of the innovation), credibly committing to compete less aggressively after licensing the innovation. Nonexclusive licensing may then result in higher industry profits by inducing coordinated pricing of the basic product and the innovation.
Another option for the innovating firm is to ask for a royalty for each unit of output produced with the innovation. In general, a royalty influences the firms’ decisions in two ways. First, it reduces the licensor’s incentives to use the licensed technology, because using the technology cannibalises royalty revenues. Second, the royalty changes the marginal cost of production on which the licensee bases its decisions. Interestingly, the authors show that under certain conditions a royalty may be used as a commitment device enabling the licensor to credibly – and without cost – establish exclusivity. They specify conditions under which a royalty allows the licensor to credibly commit not to use the licensed technology without introducing any distortion in prices.
International Journal of Industrial Organization, February 2002
