13Impact of Licensing Schemes on the Private Value of a Patent
Research Fellow: Hiroaki Ino

The market value of technology development is affected by patent license strategies. Two patent
licensing systems are commonly used: the royalty system (a patent fee payment system based on
production volume) and the fixed fee system (a payment system not affected by production volume).
[Kamien Tauman, 1986] (hereinafter referred to as KT) made a comparison between the royalty system andthe fixed fee system and game-theoretically demonstrated that the profits gained by technology innovators
under the fixed fee system are greater than those gained under the royalty system. This finding, as an
economic theory, contradicts the reality that the royalty system is adopted in many cases of patent licensing.
Therefore, it is important to start by examining KT’s model and identify economic factors that could
overturn said finding. In this study, we have analyzed the effects of various economic factors including theexistence of uncertainty, possibility of in-house production, and difference in sales strategies on bothlicensing systems from the perspective of economics in order to determine what economic factors could
limit the applicability of said KT’s finding.

Ⅰ Introduction
The market value of technology development
is affected by patent license strategies. Twopatent licensing systems are commonly used: theroyalty system (volume-based) and the fixed fee
system (lump-sum). Under the royalty system,
royalties for a patent are collected according to
the volume of products produced by use of thepatent. In practice, said system is also called therate system or volume-based system. On theother hand, under the fixed fee system, aproducer who has paid a certain amount of fee isentitled to use a patented technology regardlessof production volume. In practice, this system iscalled the lump-sum system or fixed-fee system.
The purpose of this study is to mathematically(game-theoretically) identify the effects of these
two licensing systems on the market value oftechnology development by examining the resultsof studies on economic theories and analyses ofeconomic models.
The market value of technology development,i.e., the revenues gained by a patent holder
through technical innovation, would varydepending on which licensing system is used,even if the licensed technologies are identical. Anew technology licensed to a producer would
allow the producer to lower “production costs.”
As a result, the producer’s products produced by
the new technology would become more
profitable in the market than the products
produced by a conventional technology. Such a
difference in market profitability caused bytechnology innovation is the basis for the value of

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said innovation. The value of patented technology
generated in this way is transferred to the patent
holder in the form of license fees. The payment
systems for license fees affect the revenues ofpatent holders in various ways as described below.
First, in the phase of license negotiation, themost appropriate form of agreement would differ
depending on which licensing system is to beused. Second, in the phase of market production,
the most appropriate production method woulddiffer depending on which licensing system is tobe used. This is because “costs” for producers
include not only technical production costs but
also fees for the licenses necessary forproduction. Third, these two phases, i.e., license
negotiation
andmarketproduction,areinterdependent.
[Kamien Tauman, 1986] (hereinafterreferred to as KT) established an economic model
based on two concepts, i.e., license negotiationand market production. KT used this model tocompare the royalty system with the fixed fee
system and demonstrated that the fixed fee
system is more profitable for patent holders. Thisfinding of KT contradicts the reality that theroyalty system is adopted in many cases of patent
licensing. Therefore, it is important to start byexamining KT’s model and identify economic
factors that could overturn KT’s finding. A
theoretical analysis would be necessary to find away to close the gap between KT’s finding andreality. In order to carry out such analysis, three
economic factors, i.e., the existence of● 96 ●

uncertainty, possibility of in-house production,and difference in sales strategies, must be taken
into consideration. This study examines thosefactors from the perspective of economics.

Ⅱ Analysis by Kamien & Tauman[Kamien Tauman, 1986] was first to analyze
the relation between the profits brought bypatents to technical innovators and the type oflicensing
systemthroughmathematical(game-theoretical) formulation. In this attempt,
they established an economic model based on two
concepts, i.e., licensing negotiation and market
production, and used this model to make acomparison between the royalty system and thefixed fee system in terms of license revenues
obtained thereunder. Main propositions madebased on the results of the comparison are asfollows.
Proposition 1 [Kamien Tauman, 1986]
The license revenues obtained by a patent
holder under the fixed fee system are higher thanthose gained under the royalty system. The
difference between the two systems becomes
smaller with the intensification of market
competition.
In principle, they made a proposition that thefixed fee system is superior in terms of license
revenues, while admitting that the difference
between the two systems becomes smaller with
the intensification of market competition. The
economic grounds for this finding can be inferred
as follows based on the mathematical structure ofthe model.
In the case of the royalty system, an increasein unit royalty has two effects trading off eachother on the license revenues. One of the effects
is that of increasing the amount of the license fee
per production unit, which is a direct effect of anincreasing unit royalty. The other is an indirect
effect of affecting the production plan of theproducer. Although the marginal cost has been
reduced by a new technology, a rise in unit
royalty would lead to a rise in costs of increasing
production. Consequently, the marginal costconsisting of production costs and license costs
would climb, reducing the benefit of the newtechnology for the producer. As a result, themarket production volume of the producer
declines after a rise in unit royalty. This would
impair the use of licensed technology, having anegative effect on the license revenues.
In contrast, such trade-off does not occur
under the fixed fee system because a fixed fee isa cost already determined regardless of theproduction plan. Therefore, a fixed fee has noeffect on the marginal cost and no influence on
the production volume determined according toan optimum production plan. Such a cost
constantly and inevitably incurred by a producer
when increasing production volume is called sankcost. Sank cost is generally known to have noeffect on the optimum decision making process ofan economic entity. Therefore, under the fixed
fee system, a producer can enjoy the benefit oftechnical innovation in the form of an actual
increase in market profits caused by theintroduction of a new technology. This is why therevenues obtained under the fixed fee system arehigher than those obtained under the royaltysystem, which is disadvantaged by a trade-off that
could occur in the course of license fee collection.
In reality, however, the royalty system isvery commonly used as a method of license fee
payment. Within the framework of the economic
environment presumed in KT’s theoretical model,
it is impossible to identify the factors causing
such a wide use of the royalty system in reality.
In order to identify, from the perspective ofeconomics, the economic factors missing fromthe model, which cause companies to choose theroyalty system over the fee fixed system, wehave formulated hypotheses about each of thefollowing three factors, which are selected asreasons for the advantage of the royalty systemover the fixed fee system from the viewpoint ofsystem users.
1

Existence of uncertainty

Usually, when a license agreement isconcluded, the future market demand created by
the technology in question is unpredictable. The
contracting parties have to carry out licensing
negotiation based on their prediction for market
size. If the level of uncertainty is high, the fixed
fee system would be less likely to be chosen than
the royalty system, which allows the collection
and payment of license fees according to the sales
volume.
2

Possibility of in-house production

It is not uncommon that one economic entity
doubles as a patent holder and a producer andthat the patent holder itself produces products in● 97 ●IIP Bulletin 2009

the market by use of the patented newtechnology in competition with other producers.
When this is the case, in consideration ofstrategic interdependence in the competitivemarket, it would be more advantageous to impose
royalties on rival producers.
3

Difference in sales strategies

In general, a low-margin high-turnoversales strategy is not necessarily inferior to theopposite sales strategy, i.e., high-margin
low-turnover. The fixed fee system is suitable forcases where each producer produces products ingreat quantity by using the licensed technology.
On the other hand, the royalty system is suitablefor cases where a licensed technology is used forsmall volume production. Therefore, the royalty
system is an effective means of selling
technologies for a large number of products at alow margin.

Ⅲ Further Consideration of EachFactor
1

Existence of uncertainty

In this section, we introduced the factor ofuncertainty into the model described in Chapter
II and discussed cases where the future market
demand created by a new technology is uncertain
when a license agreement is concluded for thetechnology. In such cases, the royalty system mayseem more advantageous than the fixed fee
system because the royalty system allows thecollection and payment of license fees according
to the actual demand, i.e., the sales volume.
However, as long as both the patent holder(licensor) and producer (licensee) face the risk ofmarket demand uncertainty with the same frameof mind, Proposition 1 remains uncontroverted.
In other words, the mere existence of uncertainty
cannot explain the superiority of the royalty
system for the following reason. Since thedemand is predicted only as an expected value,
the same mechanism as that which would beemployed if the demand were predictable would
cause the marginal cost to rise only under theroyalty system, making the license revenues
smaller than the revenues that could be obtained
under the fixed fee system on average.
This analysis result suggests that the mere
existence of uncertainty would not constitute aIIP Bulletin 2009

theoretical explanation for superiority of theroyalty system. The analysis result was derived
based on extremely simplified conditions where
both the licensor and licensee face the risk of
uncertainty with the same frame of mind.
Therefore, in order to consider the existence ofuncertainty as a reason for an advantage of theroyalty system, it is necessary to take into
consideration the aforementioned conditions inaddition to the analysis result described above.
2

Possibility of in-house production

So far, our analysis has been based on thepresumption that a patent holder and a producer
are different economic entities. In an actual
economy, however, a patent holder itself often
produces products in the market by using thepatented new technology and competes withother producers. [Wang, 1998] applied the model
described in Chapter II to cases where a patent
holder engages in in-house production and madea comparison between the fixed fee system andthe royalty system. The results of comparison are
as follows.
Proposition 2 [Wang, 1998]
If a patent holder produces products by using
the patented new technology and participates in
the market as a producer, the total of license
revenues and market profits obtained by thepatent holder can be higher under the royalty
system than those obtained under the fixed feesystem.
This means that the aforementioned findingof [Kamien Tauman, 1986] could be overturned incases where a patent holder pursues market
profits.
The reason for this finding is explained fromthe perspective of economics as follows. The
mechanism explained in Chapter II is applicableto the case of in-house production as well. In
comparison with licensing under the fixed fee
system, licensing under the royalty system ismore likely to cause the marginal production costof the licensed company to rise, decreasing its
license revenues. On the other hand, since apatent holder participates in market competition
as a producer, licensing of the patented
technology to other producers would intensify
the competition among those who are entitled touse the new technology. Licensing of the newtechnology under the royalty system would
increase the marginal production cost of rival● 98 ●

companies, increasing the market profits of thepatent holder by easing the competition. In otherwords, the effect of the increasing marginal costobserved only under the royalty system
negatively affects the license revenues but, at thesame time, positively affects the market profits
gained by the patent holder. When the positiveeffect is stronger than the negative effect, thetrade-off between the positive and negative
influences gives an advantage to the royalty
system over the fixed fee system.
3

Difference in sales strategies

So far, we analyzed license revenues
obtained under the optimum license agreement.
However, we have not examined thecharacteristic of sales strategies adopted undereach license system. Just as there are sales
strategies for ordinary goods such as a
low-margin high-turnover sales strategy, there
should be sales strategies for technologies. From
this perspective, the royalty system seems to besuitable for cases where the licensed technology
is used for small volume production. This meansthat the royalty system is an effective means ofselling technologies to a large number of
producers at a low margin. In this section, we
have presented an economic model to support
this intuitive view.
In examining why KT’s economic model does
not support a low-margin high-turnover sales
strategy, which would be adopted by an optimum
agreement under the royalty system, we havefound that one of the fundamental reasons is theuse of a cost function with constant marginal costin their basic model. The use of such a costfunction means that the analysis is conducted on
the economic presumption that a single firm has
no limit to its production capacity and therefore
would not see its marginal productivity decrease
due to such limit. Based on this presumption, acompany that has adopted a sales strategy that
may be summarized as “large-volume sales to asmall number of customers” would not see a dropin productivity due to the limited capacity of eachproducer. As a result, the superiority of theopposite sales strategy, i.e., low-margin
high-turnover, would not be recognized.
The result of this analysis on production
costs implies that one of the fundamental reasonsfor the suitability of the royalty system for alow-margin high-turnover sales strategy lies in adrop in marginal productivity. This study has
proved such suitability by generalizing the costfunction used in KT’s model in order to introduce
the possibility of decrease in marginal
productivity. The result of the study has shown
that, as is the case where the marginal cost is
constant (linear), the license revenues under thefixed fee system are higher than those under theroyalty system as long as the market ismonopolistic and has only a small number of
producers participating therein. As mentioned
earlier, this is because the royalty system is
disadvantaged by the effect of an increment ofmarginal cost, which is dominant in such a market.
However, in contrast to a case where themarginal cost remains constant, in a competitivemarket with a large number of producers
participating therein, the license revenues under
the royalty system exceed those under the fixed
fee system.
This finding may be explained as follows
from the perspective of economics based on themodel structure. Under the royalty system, alow-margin high-turnover sales strategy tends tobe adopted in order to avoid the problem ofcapacity limitation (the possibility of decrease in
marginal productivity) by diffusing the patented
technology among a large number of producers.
This allows effective production by thoseproducers, increasing the value of the newtechnology in the market as a whole. The morecompetitive the market is, the larger the numberof producers to whom the new technology could
be licensed, leading to wider use of thetechnology. Consequently, the license revenueswould grow. On the other hand, under the fixed
fee system, an opposite sales strategy tends to beadopted. Under such a strategy, the number oflicensees would be limited. In other words, newtechnology would be disclosed only to a certain
degree, leading to rather monopolistic use of thetechnology. This would lead to mass production
by each licensee, who tends to face the problemof capacity limitation as a result. An increase in
marginal cost would reduce the effectiveness ofthe use of new technology, decreasing the valueof the technology in the market as a whole. This
structure explains why an increase in license
revenues observed under the royalty system with
the intensification of market competition isgreater than that observed under the fixed fee
system.

Ⅳ Conclusion
The findings and outline of analysis
conducted in this study may be summarized as● 99 ●IIP Bulletin 2009

follows. First, we introduced KT’s research andshowed that the royalty system has a structurallimitation that prevents the license revenues
from exceeding those that would be obtained
under the fixed fee system. This limitation iscaused by the effect of an increasing marginal
cost, which decreases the benefit of newtechnology. Second, we analyzed cases wheremarket demand is unpredictable when a license
agreement is concluded, and concluded that, aslong as both the licensor and the licensee face therisk of market demand uncertainty with the same
frame of mind, we cannot overturn theproposition that the royalty system is inferior
because of the effect of an increasing marginalcost. Third, we argued that, if a patent holder
participates in the market as a producer, theroyalty system would be advantageous because
the effect of the increasing marginal costobserved only under said system makes rival
companies less competitive. Finally, we examined
the sales strategy adopted to sell technologies
under each license system and identified thedifferences. The examination revealed that theroyalty system, which is compatible with alow-margin high-turnover sales strategy, tends tobe adopted in an economic environment where
the market competition is intensive and marginalproductivity is decreasing.

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