The Optimal Scope of the Royalty Base in Patent Licensing

Legal scholars debate the merits of using the total value of the product, as opposed to the value of the component to which the technology contributes, as the base for a royalty in licensing contracts. In this paper we make use of the fact that these two royalty bases are equivalent to using ad valorem and per-unit royalties, respectively. We abstract from implementation and practicability considerations to analyze the welfare implications of the two rules. Ad valorem royalties tend to lead to lower prices, particularly in the context of successive monopolies. They benefit upstream innovators and do not necessarily hurt downstream producers. This benefit increases when there are multiple innovators contributing complementary technologies, as is typical of standard-setting organizations. Ad valorem royalties are even more desirable when enticing upstream investment is optimal. Our findings explain why most licensing contracts include royalties based on the value of the product.