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Licensing interim R&D knowledge

Explore the benefits and drawbacks of licensing interim R&D knowledge in the pharmaceutical and biotech industries, including the impact on value creation, value destruction, and rent extraction. Analyze the factors that influence the decision to license or sell superior knowledge to lagging firms.

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Licensing interim R&D knowledge

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  1. Licensing interim R&D knowledge Yossi Spiegel Tel Aviv University

  2. Background • Many licensing agreements are reached in early stages of the R&D process • A 1/3 of all licensing deals between the top 12 pharmaceutical companies and biotech firms in 1991-2002 took place during preclinical testing (Kalmas, Pinkus, and Sachs, 2002) • Over 60% of all licensing deals between the top 20 pharmaceutical companies and biotech firms in 1997-2002 took place at the discovery and lead molecule phases (Howard, 2004) • About 50% of all biotechnology licensing agreements in Lim and Veugelers (2003) were made at the preclinical testing stage • The success rate for drugs at the preclinical testing stage is low (about 20% - see DeMasi, 2001) Licensing interim R&D knowledge

  3. The main idea • Consider a winner-takes-all R&D contest for developing a new commercial technology (e.g., new drug, new cost effective production process) • Question:Should the leader in the contest, before it is decided, hold on to its lead or should it license/sell its superior knowledge to lagging firms? • Answer:If the leader can choose between licensing and selling the answer is YES. • If it can either license or sell (but cannot select between these two options) the answer is IT DEPENDS. • The problem differs from traditional patent licensing because what is licensed is only a chance to invent, not a sure thing (due to Bertrand competition, complete technologies will never be licensed) Licensing interim R&D knowledge

  4. Main effects of licensing • Value creation: Raises the prob. that the licensee will succeed when the licensor fails • Value destruction: Raises the prob. that the licensee will succeed when the licensor succeeds • Rent extraction: The licensor can play the licensees off against one another since a non-licensee faces a lower prob. of being the sole developer of the new technology • The rent extraction effect is similar to the blackmail effect in Anton and Yao (AER, 1994; RES, 2002) and to the effect of licensing in Katz and Shapiro (QJE, 1986) Licensing interim R&D knowledge

  5. Related literature • Kamien (Handbook of IO, 1992) - how should an outsider license a patent? • Gallini (AER, 1984) - An insider licenses knowledge to deter entry • Rockett (Rand, 1990) - An insider licenses to invite a weak rival • Bhattacharya, Glazer, Sappington (JET, 1992) - optimal design of RJV, including cross licensing of interim knowledge • d’Aspremont, Bhattacharya, Gerard-Varet (RES, 2000) – bargaining over licensing of interim knowledge under asym. info. • Bhattacharya and Gurive (JEEA, 2006) - comparison between patent-based licensing (exclusivity is feasible) and trade-secret-based licensing (exclusivity is not feasible) Licensing interim R&D knowledge

  6. The model • 3 firms engage in an R&D contest, followed by Bertrand competition • The profit from being the sole developer of the new technology is 1; otherwise the profit is 0 • Knowledge: l1 > l2 ≥ l3 • Knowledge is Blackwell ordered • The expected profits absent licensing: Licensing interim R&D knowledge

  7. Exclusive licenses • Firm 1 makes take-it-or-leave-it offers to firms 2 and 3 at fees, T2 and T3, and sets a tie-breaking rule in case both firms accept • Exclusive license to firm 2 (the case of firm 3 is analogous): Licensing interim R&D knowledge

  8. Nonexclusive licenses • The expected payoffs: Licensing interim R&D knowledge

  9. Lemma 1 • If firm 1 wishes to issue an exclusive license to firm j = 2,3, then it will set T2 and T3 such that so (accept, accept) is a NE and set a tie-breaking rule that says that firm j gets an exclusive license if both firms accept • If firm 1 wishes to issue nonexclusive licenses to both firms 2 and 3, then it will set T2 and T3 such that so (accept, accept) is a NE and set a tie-breaking rule that says that both firms get licenses if both accept • Interestingly, T2* >(<) T3* when l1 < (>) 1/2: firm 2 faces a weaker non-licensee so it values a license more, but it also cares less about being left behind Licensing interim R&D knowledge

  10. Proposition 1 – the equil. • l1 is large: a license is not worth much to firms 2 and 3 but entails a large loss of technological lead from firm 1’s perspective • l1 is intermediate: firm 3 is willing to pay more (T3>T2), but licensing to firm 2 entails a smaller loss of technological lead (firm 2 has a “good” chance anyway) • l1 is small: licensing entails a small loss of technological lead (firm 1 is “far away” anyway) and allows firm 1 to play firms 2 and 3 off against one another (a license not only provides knowledge but also ensures that the firm is not left behind) Nonexclusive licenses Exclusive license to firm 2 No licenses 1/3 1/2 l*1 1 l1 Licensing interim R&D knowledge

  11. Partial transfer of knowledge • What happens when firm 1 can control how knowledge it transfers? • Let D2 ≤ l1 - l2 and D3 ≤ l1 - l3 • Again, firm 1 makes take-it-or-leave-it offers such that rejection implies that firm 1 will transfer its entire knowledge to the rival firm. The offers are complemented by appropriate tie-breaking rule: Licensing interim R&D knowledge

  12. Partial transfer of knowledge – the equil. Nonexclusive licenses Exclusive license to firm 2 No licenses 1/3 1/2 l*1 1 l1 Nonexclusive licenses Exclusive license to firm 2 “vacuous” licenses to firms 2 and 3 Licensing interim R&D knowledge

  13. Transfer of knowledge between firms 2 and 3 • Firm 1 sets T2 and T3 such that p2 = l2(1-l1)2 and p3 = l3(1-l1)2 – the rival obtains an exclusive license • p2 + p3 = (l2+l3)(1-l1)2 - firms 2 and 3 benefit from transferring firm 2's knowledge to firm 3 and improve their bargaining positions vis-a-vis firm 1 • The agreement does not affect firm 1's choice between exclusive and nonexclusive licenses since this choice depends only on whether l1 is above or below 1/3 • Since l1* with λ₃, the agreement narrows the range of l1 for which firm 1 issues an exclusive license to firm 2 Licensing interim R&D knowledge

  14. Firm 1's knowledge is worth more to firms 2 and 3 • In many cases, relatively small firms license out their interim R&D knowledge to large corporations (e.g., software industry or biotechnology) • Suppose that when firm 1's knowledge is l1, its prob. of developing the new technology is fl1, f∈[0,1] f 1/3 l*1 1 Licenses to firms 2 and 3 Exclusive license to firm 2 No licenses l1 1/2 1 Licensing interim R&D knowledge

  15. Correlation • Suppose that after licensing, the success prob. of firm 1 and its licensee(s) become positively correlated: with prob. r, they are perfectly correlated and with prob. 1-r they are completely independent • The expected payoffs under an exclusive license to firm 2: • The expected payoffs under nonexclusive licenses to firms 2 and 3: Licensing interim R&D knowledge

  16. Correlation – the equil. • When r is not too large, the qualitative results of Prop. 1 remain valid: • Nonexclusive licenses to firms 2 and 3 when l1* is small • Exclusive license to firm 2 when l1* is intermediate • No licenses when l1* is large • When r is relatively large, things change: • Firm 1 will never issue nonexclusive licenses to both firms 2 and 3 whenever • Firm 1 will issue an exclusive license to firm 3 whenever l1 < 1/3 and Licensing interim R&D knowledge

  17. Bans on exclusive licenses • In some cases, U.S. firms were not allowed to issue exclusive licenses - in two separate consent decrees signed in 1956, AT&T and IBM were required to license their patents on a nonexclusive, world-wide basis to any applicant at a reasonable royalty • Bans on exclusive license may backfire! Nonexclusive licenses Exclusive license to firm 2 No licenses 1/3 l**1 l*1 1 l1 Nonexclusive licenses No licenses Licensing interim R&D knowledge

  18. Acquisition of knowledge • Selling differs from licensing because after firm 1 sells its knowledge, it exits the R&D contest (e.g., firm j = 2,3 acquires firm 1 or acquires the relevant R&D lab or division of firm 1) • The expected payoffs under exclusive sale of knowledge to firm 2: • The expected payoffs under nonexclusive sale of knowledge to firms 2 and 3: Licensing interim R&D knowledge

  19. Acquisition of knowledge – the equil. Nonexclusive licenses Exclusive license to firm 2 No licenses 1/3 1/(2-l3) 1/2 l*1 1 l1 Nonexclusive sale to firms 2 and 3 if (l1-l2-l3)(1-2l1) > l1l2l3 or no sale otherwise No sale Exclusive sale to firm 2 Licensing interim R&D knowledge

  20. Sell or license? Nonexclusive licenses Exclusive license to firm 2 No licenses 1/3 1/(2-l3) 1/2 l*1 1 l1 Nonexclusive sale to firms 2 and 3 if (l1-l2-l3)(1-2l1) > l1l2l3 or no sale otherwise No sale Exclusive sale to firm 2 Licensing interim R&D knowledge

  21. Conclusion • A leading firm in an R&D contest may be better off licensing or selling its interim knowledge rather then holding on to its lead • Selling is particularly attractive when the leading firm is very close to being successful because it allows to avoid competition • Licensing/selling is profitable because it may create value and may also allow the leading firm to extract rents from its rivals • Exclusive licenses may promote knowledge dissemination especially when the leading firm has a relatively high amount of knowledge Licensing interim R&D knowledge

  22. Possible extensions • Endogenize the success prob. of the three firms • Add a second investment stage after licensing takes place - for example, the overall success prob. could be p(li,ti), where ti is the ex post investment • In such a model, licensing will allow the licensee(s) to save ex post investments • Replace Bertrand competition with some other type of competitive model • Make the success prob. private info. • Knowledge is non-Blackwell ordered • Cross-licensing agreements may emerge Licensing interim R&D knowledge

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