The Entrepreneur s Dilemma: Licensing vs Commercialization by Entry

Transcription

1 The Entrepreneur s Dilemma: Licensing vs Commercialization by Entry Pedro Gonzaga University of Porto and CEF.UP eupedrogonzaga@gmail.com Hélder Vasconcelos University of Porto and CEF.UP hvasconcelos@fep.up.pt March 16, 2015 Abstract Entrepreneurs are commonly observed to commercialize their inventions by entering in the product market, instead of licensing them in a market for ideas. This well known fact constitutes an economic puzzle, as licensing appears to be a win-win strategy that increases market concentration and avoids substantial entry costs. Here we attempt to rationalize the entrepreneur s behavior in a context of implementation costs, as well as to measure the social desirability of each strategy. In addition, we predict the impact of licensing and commercialization by entry on research and development activities and we provide economic policy recommendations. Financial support from Fundação para a Ciência e a Tecnologia is gratefully acknowledged (project PTDC/EGE/ECO/117932/2010). 1

2 1 Introduction Innovation, in the sense of the introduction of new products, methods or forms of organization, is the most important and ultimate cause of sustainable economic growth. Although the accumulation of capital is crucial for new economies to increase their productive capacity and improve labour specialization, only technological progress based on frequent and high-quality innovations can sustain a continuous process of economic growth characterized by a raise in the quantity, quality and variety of goods. Indeed, Kaldor (1957) established a long ago that capital per capita is stable in the long-run and both the neoclassical 1 and endogenous theories of economic growth sustain that, once the ratio capital per worker reaches a steady state level, further growth can only be achieved with some form of technological progress that improves the marginal productivity of capital and labour. In the words of Schumpeter (1939), Surely, nothing can be more plain than the proposition that innovation, as conceived by us, is at the center of practically all the phenomena, difficulties, and problems of economic life. Among all the actors of the free market system, the entrepreneurs and start-up firms are, by far, the main responsible for most revolutionizing discoveries that improved social well-being beyond any expectable standards. This behavioral pattern is verified by a study conducted by the United States Small Business Administration, according to which small firms introduced countless breakthrough innovations such as the airplane, personal computer, microprocessor, FM radio, air conditioning, DNA fingerprinting, optical scanner, x- ray, microscope and the pacemaker. Unlike large incumbent firms well established in the market, newborn and small companies are not constrained by conservative processes or bureaucratic procedures that discourage the implementation of new, creative and risky methods. Instead, small firms are motivated by the prospective of growth and are willing to incur in all forms of risk, perhaps led by what Keynes (1936) called the animal spirits. When the entrepreneur comes up with a new idea, which may either be the outcome of R&D effort or merely the product of chance, he has alternative mechanisms to implement his invention and collect 1 see Solow (1957). 2

3 the gains from it. Traditionally, the entrepreneur is associated with the figure of the small businessman that, at his own risk, uses his own capital to introduce a new product or process into the market, while directly competing against large well-established firms - a strategy properly identified as commercialization by entry. If successful, the entrepreneur will be able to use his new competitive advantage to outrun incumbents and collect a profit, something that would be very unlikely if he had not innovated in the first place. An alternative strategy that has been progressively observed in modern economies consists in selling the new invention in a market for ideas, usually in exchange for a royalty of the sales - a solution known as licensing. Indeed, entrepreneurs have increasingly recognized that, by selling their ideas to a rival company of greater dimension or to multiple firms in different industries or markets (multi-licensing), not only they avoid considerable entry and commercialization costs, but they also earn greater revenues from a volume of transactions that they could never achieve on their own. In return, incumbents gain access to new advanced technologies and reduce the competitive pressure in the market, by deterring the entry of new entrepreneurs. Given the potential gains of licensing for all market intervenients, one would expect the entrepreneur always to reach a win-win licensing agreement with incumbents. Instead, we frequently observe small businessmen bringing innovations to markets in order to challenge, agains all odds, powerful rivals of greater dimension, a fact that remains an unsolved enigma in the economic literature. As enunciated by Gans and Stern (2000): Under the traditional assumptions of the literature on technological competition, and in the absence of non contractible information asymmetries between the incumbent and the entrant, observations of entry by the start-up into the product market represent something of an economic puzzle. In this paper, we attempt to rationalize the entrepreneur s behavior in a simple innovation model consistent with multiple equilibria, in which the potential entrant may choose to commercialize his invention through licensing, entry or both. We show that the strategy chosen crucially depends on the relative dimension of implementation costs, entry costs and the value of the innovation. We follow, in part, the setting proposed by Norbäck et al. (2013), although our model allows for multi-licensing and, more importantly, it does not assume that en- 3

4 try is market-neutral, 2 as we are concerned with the potential impact of licensing on market concentration. Then, we use our theoretical setting to measure the social desirability of licensing, which has been recognized by Baumol (2004) as an important component of the free-market growth machine. Indeed, licensing not only boosts the dissemination of knowledge by letting new innovations to be instantaneously implemented in highscale, but it also promotes the specialization in the creation of knowledge, by encouraging most creative firms to innovate and cost-efficient firms to implement the innovations. Unfortunately, the efficiency gains from this cooperative strategy usually trade-off an increase in market power, since licensing may reduce the number of new firms entering the market, increase the dimension of incumbents and even raise the likelihood of tacit collusion, a problem that has raised the concern of policy-makers. Finally, we also analyze the incentives of firms to invest in research and development and we seek a robust explanation for the empirical fact that start-ups are responsible for pontual breakthrough innovations, while incumbent firms tend to be responsible for small, incremental and less risky innovations. Previous explanations in the literature typically depend on whether start-ups are assumed to enter the product market - as in Reinganum (1983) and Damsgaard et al. (2012) -, license their invention - as in Gans and Stern (2000) - or to be acquired by a larger firm - see Henkel et al. (2015). In opposition, by considering in our model that entrepreneurs have different mechanisms available to commercialize their inventions, we show that entrepreneurs tend to engage in risky projects with high potential in order to overcome a hurdle effect, whose interpretation may differ across equilibria. The remainder of the paper is structured as follows. In section 2 we present the benchmark two-stage model of innovation. In section 3, we solve the second stage of the game and discuss three possible equilibria regarding the strategical decision of licensing or entering the market. In section 4 we analyze the R&D activity conducted by incumbents and by the potential entrant during the first stage of the game. Then, in a future version of the paper, we will compare the non-cooperative equilibrium with the social optimal and propose policy recommendations. Finally, section 5 concludes. 2 Market-neutral entry means that the new entrant forces an incumbent to exit the market, leaving the total number of firms unchanged. 4

5 2 The Benchmark Model The set of combined interactions in the creation and commercialization of new ideas can be rather complex. For that reason, we would like to propose here a benchmark model that is sufficiently simple to produce intuitive results but, at the same time, sufficiently complete to capture most relevant effects in the process of innovation. With that purpose in mind, we focus our analysis in an industry composed of n symmetric incumbent firms that sell a final product in a global market and earn a profit equal to π 0 each. There is also a potential entrant, henceforth designated by entrepreneur, that may successfully enter the market, case in which individual profits are reduced to π 1 due to business stealing. In addition, all firms may conduct R&D activities to develop a new technological product protected by a system of Intelectual Property Rights (IPR). All product innovations are completely independent, meaning they are sold in separate markets that do not interact with each other nor with the global market, as depicted in figure 1. Any firm who successfully innovates can collect the respective gains by selling the new product in the innovation market, licensing the IPR to other companies or both. More precisely, firms play a two-stage game that goes as follows. In the first stage of the game, all players incur in a fixed expenditure F in order to engage in a R&D project, which leads to a product innovation with probability of success ρ and fails with probability 1-ρ. Firms may choose among a convex set of R&D projects characterized by different quality and risk levels. Economic rationality implies that firms will only choose among projects that are in the efficient frontier and, thus, the value of the innovation V is negatively correlated with the probability of success ρ. In the second stage of the game, players who succeeded in their R&D projects, henceforth called inventors, must define the best strategy to implement the innovation. On the one hand, the inventor must decide whether or not to commercialize the patented product by entering in the innovation market (consider a dummy variable I equal to 1 under entry and 0 otherwise). On the other hand, the inventor must set the number of companies l to whom he wishes to license the technological product. The optimal value of l can be equal to 0 (no licensing), 1 (licensing) or greater than 1 (multi-licensing). Then, the licensees together with the inventor (under entry) play an oligopoly game and earn each the individual value of the innovation V(I+l,ρ), 5

6 Figure 1: Market structure of the industry Figure 2: Extensive form representation of the game 6

7 which is negatively correlated with the number of firms interacting in the innovation market (I+l) and the probability of success ρ. Because the inventor has initially the monopoly rights of the new product and there are many potential purchasers interested in acquiring the IPR, the inventor is able to charge from each licensee the individual value of the innovation, and his total revenues are given by: T R = (I + l)v (I + l, ρ). (1) There are, of course, some costs involved depending on the mechanism chosen to implement the innovation. In first place, any successful firm who wishes to license the technological product to other firms must incur in an implementation cost Γ per licensee. This value captures all legal charges, transmission of know-how costs, as well as expenses of readapting the technology or manufacture equipment of the licensee. Although implementation costs are seldom considered in the literature, they can be quite substantial in reality, as many inventions are created without considering how hard it would be to implement them in firms well-established in the market that rely on very specific production technologies. In second place, a successful entrepreneur who desires to commercialize a new product by entering in the innovation market must incur in an entry cost E, in order to adquire the complementary assets required to produce and sell the innovation, such as productive infrastructures, manufacturing equipment, marketing channels and a costumer portfolio. Because complementary assets are common to all markets, once they are acquired by the entrepreneur, he can also participate and collect the profit π 1 from the global market. Naturally, such assets are already owned by incumbent firms, who do not need to incur in any entry cost to commercialize their own innovations. The two-stage game played by the entrepreneur and incumbents is represented in the extensive form in figure 2. Next we will solve the game by backward induction, starting hence by finding the equilibrium strategies in the second stage. 7

8 3 Second Stage: Licensing vs Entry In this stage of the game, successful inventors must make entry and licensing decisions (I and l) to maximize the gains from their innovations. At this point, once the variable ρ was already fixed in the first stage, we can treat it as a parameter and omit it from the value function V. We will use the subscript i and e to refer to an incumbent and to the entrepreneur respectively. We start by analyzing the optimal strategy played by an incumbent. 3.1 The Incumbent s Strategy An incumbent who owns an innovation is faced with the problem of choosing I i and l i to maximize the following payoff function: U i = (1 I e )π 0 + I e π 1 + (I i + l i )V (I i + l i ) Γl i, (2) where the two first terms correspond to the profit earned in the global market (which depends on the entrepreneur entry decision), the third term is the value collected from the innovation market and the forth term is the implementation cost from licensing the product. Given that the marginal value of the innovation is non-negative, it is straightforward that the incumbent always chooses to enter the innovation market, meaning that I i is equal to one. Thereby, the problem of the incumbent can be reduced to the choice of l i that maximizes the payoff function rewritten as: U i = (1 I e )π 0 + I e π 1 + (1 + l i )V (1 + l i ) Γl i. (3) Proposition 1 An incumbent who successfully innovates has two equilibrium strategies. Licensing equilibrium: when V (1) + V (1) > Γ, the incumbent enters the innovation market and licenses the product to l i * firms, where l i * is the solution of equation (4). V (1 + l i ) + (1 + l i )V (1 + l i ) = Γ. (4) No Licensing equilibrium: when V (1)+V (1) < Γ, the incumbent enters the innovation market as a monopolist. Proposition 1 has the following interpretation. If the incumbent s optimal strategy involves licensing the innovation, the incumbent should 8

9 sell the IPR to a number of firms such that the additional revenue of an extra licensee equals the implementation cost. The marginal revenue of licensing, given by the left-hand side of equation (4), corresponds to the value that the innovation has in the hands of the extra firm minus the cost imposed on the other firms, due to a more intense competition in the innovation market. The optimal licensing level is graphically represented in Figure 3 at the point where the marginal revenue curve intersects the implementation cost. However, if the marginal revenue of licensing given that the incumbent is alone in the innovation market is less than the marginal cost of implementing the innovation (V (1) + V (1) < Γ), the best strategy is not to license at all and to commercialize the product as a monopolist - Figure The Entrepreneur s Strategy We move now to the strategy played by the entrepreneur, whose payoff function is given by: U e = I e (π 1 E) + (I e + l e )V (I e + l e ) Γl e. (5) As we can see from the first term in the right-hand side of equation (5), the entrepreneur must incur in an entry cost E to purchase the complementary assets required to enter the industry, case in which he is not only able to earn the value of the innovation, but also to collect the profit π 1 from the global market. The two last terms of the payoff function are equivalent to those regarding equation (2). Consider now the following assumptions: Assumption 1 π 1 > 0 and π 1 E < 0. Assumption 2 V (1) + V (1) > E π 1. The two conditions in assumption 1 mean the global market is in equilibrium, as no insider wants to exit (positive profits) and no outsider wants to enter without an innovation (full market). Assumption 2 guarantees that, as long as the entrepreneur innovates, entering is profitable, though it may not be the best strategy. This condition excludes from our analysis monopolized industries where the only strategy available for start-ups is to license or to be acquired by greater companies, as in the Electronic Design Automation Industry described by Henkel et al. (2015). 9

10 Incumbent V (1 + l i ) + (1 + l i )V (1 + l i ) Monetary Units Γ l i Licensing (l) Figure 3: Licensing Incumbent V (1 + l i ) + (1 + l i )V (1 + l i ) Γ Monetary Units l i Licensing (l) Figure 4: No licensing 10

11 Under assumptions 1 and 2, it is possible to prove the next proposition. Proposition 2 An entrepreneur who successfully innovates has three equilibrium strategies. Entry and Licensing equilibrium: when V (1) + V (1) > Γ > E π 1, the entrepreneur enters the global market and the innovation market, and he licenses the technological product to l e firms, where l e is the solution of: V (1 + l e) + (1 + l e)v (1 + l e) = Γ. (6) No Entry and Licensing equilibrium: when Γ < E π, the entrepreneur does not participate neither in the global market nor in the innovation market, and he licenses the technological product to l e firms, where l e is the solution of: V (l e) + l ev (l e) = Γ. (7) Entry and No Licensing equilibrium: when V (1) + V (1) < Γ, the entrepreneur enters the global market and the innovation market, where he acts as a monopolist. The two former equilibria in Proposition 2 have the following interpretation. When licensing is a viable solution, the entrepreneur has the choice of entering or staying out of the market, a decision that will ultimately depend on the relative dimension of the implementation cost (Γ) and the net entry cost (E π 1 ). If the implementation cost exceeds the net entry cost, the entrepreneur finds more efficient to enter the market instead of licensing the product to an additional firm. If the implementation cost is smaller than the net entry cost, the entrepreneur stays out of the market, as all licensees can more efficiently implement his innovation than him. Regardless of the entry decision, the entrepreneur always licenses the innovation to a number of firms such that the revenue from an additional licensee equals the implementation cost. The two licensing equilibria are thus represented in Figures 5 and 6 at the point where the marginal revenue curve intersects the implementation cost line. Note, however, that the relevant marginal revenue curve of the entrepreneur has now a discontinuity, once the expression is given by the left-hand side of equation (6) under entry and by equation (7) otherwise. 11

12 The last equilibrium in proposition 2 resembles the no licensing equilibrium in proposition 1: when the cost of implementing the innovation into an external firm is too large and exceeds the revenue from selling the IPR to the first licensee, the entrepreneur prefers to enter the innovation market as a monopolist, as licensing is too costly. This scenario is depicted in Figure 7, where the marginal revenue curve and implementation cost line do not intersect. As a final remark, it comes directly from equations (6) and (7) that, when the entrepreneur stays outside the market, he licenses the IPR to exactly one more company than he would under entry: le = 1 + l e. (8) Ie=0 Ie=1 The intuition for this result is straightforward. The optimal number of firms commercializing the technological product in the innovation market depends only on the quality of the innovation, and not on the implementation strategy. This number should be sufficiently large to guarantee that a great share of the market is supplied, but sufficiently small to avoid intense competition and cost inefficiency. Hence, under symmetry, an entrepreneur that stays out of the market must hire exactly one extra licensee to replace his role as a seller in the innovation market. This outcome is graphically represented in Figure Divergent Strategies The distinct starting positions of the entrepreneur and incumbents at the moment of the invention inevitably leads to different implementation strategies across firms. As it was previously shown, incumbents always choose to commercialize their innovations by sale, since they do not bear the cost of acquiring complementary assets nor the cost of learning and readapting the new technology. On the contrary, for entrepreneurs, the decision of commercializing by sale critically depends on the relative dimension of implementation and net entry costs. Likewise, optimal licensing levels may also vary across firms, whose equilibrium relation is given in the next proposition. Proposition 3 Suppose the entrepreneur and incumbents come up with an innovation of identical value. Then, the following relation between optimal licensing is verified: l e = l i + (1 I e ). (9) 12

13 Entrepreneur V (I e + l e ) + (I e + l e )V (I e + l e ) Monetary Units Γ E π 1 l e Licensing (l) Figure 5: Entry and licensing Entrepreneur V (I e + l e ) + (I e + l e )V (I e + l e ) Monetary Units E π 1 Γ Licensing (l) l e Figure 6: No entry and licensing 13

14 Entrepreneur V (I e + l e ) + (I e + l e )V (I e + l e ) Γ Monetary Units E π 1 l e Licensing (l) Figure 7: Entry and no licensing Entrepreneur V (I e + l e ) + (I e + l e )V (I e + l e ) Monetary Units E π Licensing (l) Figure 8: Entry effect 14

15 Proposition 3 reflects the fact that, whenever the entrepreneur enters the market, and for innovations of identical quality, the licensing levels must perfectly match, as the entrant and incumbents are symmetrical in all remaining aspects. Nevertheless, if the entrepreneur chooses not to commercialize by sale, it must license the IPR to one more firm than incumbents, in order to offset its absence from the innovation market. Of course, the relation in equation (9) can easily be broken if firms engage in different R&D efforts and come up with dissimilar inventions, a problem we will treat in the next section. 4 First Stage: R&D Project The analysis of incumbents and entrepreneur s incentives to invest in R&D has been a central problem to the economic researcher, particularly since Gilbert and Newbery (1982) raised the concern that great incentives for the incumbent to innovate could lead to the persistency of monopoly. Thereafter, Reinganum (1983) showed that as long as the process of innovation is stochastic, small entrants can actually challenge incumbents by engaging in sufficiently revolutionary innovations. In this section we also address the problem of R&D investment as a stochastic process but, in opposition to the extant literature, we introduce the additional consideration that successful projects can be implemented through alternative mechanisms. In this stage of the game, the problem of the firm is hence to choose a research project to maximize the expected payoff from the innovation, taking into account the alternatives of licensing or commercializing by sale in the second stage. As in Damsgaard et al. (2012) and Henkel et al. (2015), the choice variable is the probability of success ρ, which reflects the risk of the R&D project and is negatively correlated with the value of the innovation in case of success. The expenses in R&D are fixed and equal to F for every project. As before, we derive the optimal strategy for the incumbent and the entrepreneur. 4.1 The Incumbent s Project An incumbent firm that participates in the global market and has the opportunity of developing a new technological product to transact in 15

16 an innovation market has the following expected payoff function: E[U i ] =(1 I e )π 0 + I e π 1 + [ (1 + ρ i + li (ρ i ) ) V ( ) ] 1 + l i (ρ i ), ρ i li (ρ i )Γ F. (10) The first two terms in equation (10) correspond, as previously, to the profit earned in the global market, which is not affected by the success of the R&D project. The third term is the expected gain from the innovation, which can be decomposed into the actual gain collected in the innovation market times the probability of success ρ i. The last term is the fixed expenditure in R&D. Then, it is the job of the incumbent to set the decision variable ρ i taking into account not only its direct impact on expected payoffs, but also its indirect effect through changes in licensing at the second stage of the game. To account for the last factor, the number of licensees l i is written in equation (10) as a function of ρ i. Proposition 4 In equilibrium, the incumbent chooses the research project whose probability of success ρ i fulfills the following condition: [ [1 + l i (ρ i )] V (.) Γ + ρ i ] V (.) ρ = Γ. (11) i The equilibrium condition presented in Proposition 4 can be interpreted as follows. The left-hand side of equation (11) is the marginal effect of choosing a safer project on the expected payoff of the incumbent, under the conjecture that the innovation is exclusively implemented through licensing to external companies. The right-hand side is the cost saving due to the fact that the incumbent always commercialize the innovation by entry and is able to hire one less licensee. The solution of equation (11) is then an interior maximum as long as the marginal expected payoff of a safer project is decreasing in ρ i, which occurs whenever the negative correlation between the value of the innovation and the probability of success is sufficiently accentuated. It also follows from Proposition 4 that the R&D project ρ i chosen by the incumbent is marginally safer than the project ˆρ i that maximizes the expected gains from an innovation exclusively implemented through licensing. That is, 16

17 [ ] ρ V (.) i > ˆρ i, where [1 + l i (ˆρ i )] V (.) Γ + ˆρ i = 0. (12) ˆρ i In order to prove this outcome, remark that an incumbent can improve his expected payoff by slightly increasing the probability of success of the R&D project from ˆρ i, case in which the firm tradesoff a first-order increase of the expected cost saving in Γ, against a second-order reduction of the expected gains from the innovation. In conclusion, the fact that incumbents are well-established in the market and can easily commercialize their own innovations by entry constitutes an incentive to pursue safer R&D projects of lower value, in order to increase the likelihood of introducing a new product while saving considerable implementation costs. 4.2 The Entrepreneur s Project We find now the equilibrium R&D project chosen by the entrepreneur at the first stage of the game, whose expected payoff function is given by: E[U e ] =ρ e I e (π 1 E)+ [ (Ie ρ e + l e (ρ e ) ) V ( ) ] I e + l e (ρ e ), ρ e le (ρ e )Γ F. (13) The first term in equation (13) accounts for the profits earned in the global market net of entry costs. Because this component is negative, it can only be actually realized by the entrepreneur in case the research project succeeds with probability ρ e. The second term is the expected gain from the innovation and the third term is the fixed expenditure in R&D. Just as in the previous section, the number of licensees l e appears in the equation as a function of the probability of success ρ e, since the entrepreneur anticipates how his licensing strategy in the second stage will react to the current choice of the R&D project. The same is not true for the other decision variable, I e, which is not affected by the dimension of ρ e. This is due to the fact that the entry decision does not depend on the risk or value of the innovation, but only the relative dimension of entry and implementation costs. Under these considerations, the next statement is true. 17

18 Proposition 5 In equilibrium, the entrepreneur chooses the research project whose probability of success ρ e fulfills the following condition: [ ] [I e + l e (ρ e)] V (.) Γ + ρ V (.) e ρ = I e [E π 1 Γ]. (14) e Again, the left-hand side of equation (14) is the variation in the expected gains in the innovation market from choosing a marginally safer project, under the supposition that the innovation is exclusively implemented through licensing to I e + l e external companies. The right-hand side of equation (14) is the cost saving from entering the market and incurring in the net entry cost, instead of paying an additional implementation cost (note that I e = 1 if E π 1 < Γ). Naturally, the equilibrium R&D project depends on the conjecture about the entry decision in the second stage. If I e = 1, the term in the right hand side of equation (14) becomes zero and the entrepreneur actually maximizes the expected gains from an innovation exclusively implemented through licensing. If I e = 0, the term is negative and equal to the difference between the net entry cost and the implementation cost. In this case, the entrepreneur chooses a marginally safer project, as he trades-off a first order increase in expected cost savings against a second order decrease in the expected gain from the innovation. 4.3 Hurdle Effect Having analyzed so far the individual incentives to invest in R&D, we can now compare the research projects chosen in equilibrium by incumbents and the entrepreneur, in order to distinguish the type of innovation that each player is likely to come up with. Proposition 6 Everything else constant, the entrepreneur chooses an R&D project of high risk and great value (in case of success), while incumbents invest in R&D projects of low risk and low value, that is, ρ e < ρ i, (15) where the differential ρ i ρ e is positively correlated with a hurdle effect given by: { E π 1 > 0, if I e = 1 Hurdle Effect = Γ > 0, if I e = 0. (16) 18

19 Proposition 6 can be proved using equation (9), as well as the optimal conditions in equations (11) and (14). The economic interpretation is detailed below. For an identical probability of success, the entrepreneur and incumbents have equal expected marginal gains from an innovation that is exclusively licensed. However, the two types of firm face different cost savings in case of success, since the incumbent is able to use his market position to save an implementation cost Γ, while entrepreneurs can only save the implementation cost minus the net entry cost (Γ (E π 1 )) under entry and zero otherwise. The difference between the cost saving of incumbent and entrepreneur is designated by the hurdle effect - equation (16) - which stands for the additional obstacle an entrepreneur must overcome in order to commercialize his innovation. Due to the hurdle effect, incumbents have strong incentives to invest in safer R&D projects, as they want to increase the probability of developing a successful invention and benefiting from their cost advantage over entrepreneurs. Likewise, the hurdle effect creates an incentive for the entrepreneur to invest in riskier projects, so that in case of success his additional cost over incumbents is dispersed and offset by an innovation of high value. This result sustains the empirical evidence that start-ups are usually responsible for revolutionary discoveries from time to time, while large established firms are the authors of constant and incremental innovations. Remark from equation (16) that the hurdle effect exists regardless of the implementation strategy followed by the entrepreneur: under commercialization by entry, he must pay the net entry cost, which is not supported by incumbents; under licensing, he must incur in an extra implementation cost than incumbents, in order to offset his absence from the market. This outcome extends the result of Damsgaard et al. (2012), who prove the existence of a hurdle effect under the hypothesis of commercialization by entry. 4.4 Licensing Differential It was previously asserted in Proposition 3 that, for innovations of identical quality, the entrepreneur multi-licenses his discovery either to as many licensees as the incumbent, or to one extra licensee should he not participate in the product market. We wonder now how the licensing differential between firms is affected under the hypothesis 19

20 sustained in the last section regarding the type of R&D projects engaged by each player. Proposition 7 Suppose the entrepreneur undertakes an R&D project ρ e and an incumbent undertakes the R&D project ρ i, where ρ e < ρ i. Then, if the two firms are successful, the optimal licensing levels verify the next condition: l e(ρ e) > l i (ρ i ) + (1 I e ). (17) The statement in Proposition 7 suggests that entrepreneurs license their innovations to more external companies than incumbents do, for two different reasons. As before, since entrepreneurs sometimes choose not to commercialize by entry, they sell their innovation to one additional company to compensate their absence from the product market. In addition, because entrepreneurs usually take greater risks in the process of research and development, if they are lucky they also produce innovations of high value, increasing the marginal revenue of an extra licensee and raising the optimal licensing level. Figures 9 and 10 illustrate graphically the licensing differential with and without entry by the entrepreneur. 5 Conclusions In this work, we propose a theoretical framework that is consistent with three important empirical facts typically observed in the process of innovation: 1. Incumbent firms well established in the market are usually responsible for many incremental inventions of low value, while entrepreneurs tend to engage in riskier projects that, when successful, lead to breakthrough innovations; 2. Entrepreneurs or start-ups who come up with new inventions are observed to implement their ideias through different mechanisms, as commercialization by entry or licensing (or both); 3. Entrepreneurs license their inventions more frequently and to a larger number of external companies than incumbents. In our setting, the first empirical fact is explained by the hurdle effect, which consists in all additional costs entrepreneurs must support to commercialize their inventions, due to the fact that they are 20

21 Entrepreneur vs I ncumbent V (1 + l i ) + (1 + l i )V (1 + l i ) V (I e + l e ) + (I e + l e )V (I e + l e ) Monetary Units Γ l i Licensing (l) l e Figure 9: Licensing differential (no entry) Entrepreneur vs I ncumbent V (1 + l i ) + (1 + l i )V (1 + l i ) V (I e + l e ) + (I e + l e )V (I e + l e ) Monetary Units Γ l i l e Licensing (l) Figure 10: Licensing differential (entry) 21

22 not initially operating in the market. In order to overcome the hurdle effect, entrepreneurs are forced to engage in risky projects with great potential so that, in case of success, the higher costs are offset by the greater value of the innovation. Then, we show that the empirical observation of alternative strategies to implement an innovation is consistent with economic rationality and results from a cost-efficiency analysis. In order to choose among licensing and commercialization by entry, the entrepreneur weights the legal and economic costs of transferring the technology to external firms, against the costs of acquiring the necessary complementary assets to commercialize the new product in the market. As regards to the licensing differential between firms, this result is sustained here by two distinct effects. On the one hand, the fact that entrepreneurs are responsible for revolutionary ideas of higher value implies that they can profitably license the innovation to a greater amount of external firms. On the other hand, when entrepreneurs choose not to enter the product market, they automatically have to license the innovation to one more company than incumbents, in order to replace their own role as a seller. The framework presented here will be used in a future version of the paper to measure the social desirability of alternative economic policies, such as R&D support and license regulation. References Baumol, W. J. (2004). Entrepreneurial enterprises, large established firms and other components of the free-market growth machine. Small Business Economics, 23(1):9 21. Damsgaard, E. F., Norback, P.-J., Persson, L., and Vasconcelos, H. (2012). Why entrepreneurs choose risky r&d projects - but still not risky enough. IFN Working Paper 926. Gans, J. S. and Stern, S. (2000). Incumbency and R&D incentives: Licensing the gale of creative destruction. Journal of Economics & Management Strategy, 9(4): Gilbert, R. J. and Newbery, D. M. G. (1982). Preemptive patenting and the persistence of monopoly. The American Economic Review, 72(3):

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