Competition Policy Center

We analyze patent licensing by a patent holder to downstream technology users. We study how the structure and level of royalties depends on the patent’s strength, i.e., the probability it would be upheld in court. We examine the social value of determining patent validity before licensing, in terms of deadweight loss (ex post) and innovation incentives (ex ante). When downstream users do not compete against each other or the patent holder, license fees approximate the license fee for an ironclad patent times the patent strength, and reviewing validity before licensing would be unproductive (in expected value). But when downstream users compete, two-part tariffs for weak patents have high running royalty rates, combined with a negative fixed fee, and examining patent validity generates social benefits, both ex post and ex ante. Even without negative fixed fees, rival downstream firms will accept relatively high running royalties, so determining patent validity prior to licensing is socially beneficial.