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The modern corporation is characterized both by a separation of ownership from management and by managerial incentives that often include strategic elements in addition to the standard incentive elements. Despite the importance of these two features in the agency and corporate‐governance literatures, they are absent in the treatment of the firm in the patent‐licensing literature. The analysis in this paper shows how, by simply taking into account these two features of the modern corporation, it is possible to offer a new explanation for the use of royalties in licensing agreements.

This paper studies the optimal two‐part tariff licensing contract for an internal patentee in a differentiated Cournot duopoly. We find that the type of the royalty payment, whether ad valorem or per‐unit, that it is optimal for the patentee depends on the kind of goods produced in the industry, more precisely on whether they are substitutes or complements and on the degree of product differentiation. We also find that licensing always increases social welfare, although it may hurt consumers.

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The analysis in this paper uncovers a heretofore unrecognized connection between the degree of competitive behavior in the product market and the preferred patent licensing mechanism. Using conjectural variations as a shorthand for several different supergame outcomes of a duopoly industry, we show that both the degree of competitive behavior and the extent of the asymmetries in the behavior of the firms in the market have a non-trivial effect on the patent licensing mechanism preferred by an external patentee. The relationship between the degree of competition in product markets and the preferred patent licensing mechanism, to the best of our knowledge, has not been addressed in the literature previously and represents a useful source of new empirical implications.