Licensing with free entry

We introduce a fairly general licensing model with an endogenous industry structure - in terms of number of active firms - and general licensing contracts. We show that when the innovator can employ contracts that can condition on licensee quantity and revenue, it can implement an outcome that yields monopoly profits by awarding the license to a single firm. Commonly assumed two-part tariff contracts cannot replicate this outcome, but still perform better than fixed-fee or proportional fee contracts. The key to the effectiveness of licensing contracts lies in their ability to deter the entry of non-licensees who use the old technology while keeping the number of licenses low. We discuss the welfare implications of various contractual schemes.