Expert economist Jorge Padilla (Compass Lexecon) and Koren W. Wong-Ervin (Axinn) consider the merits of recent complaints about the common practice in technology industries of licensing patents to manufacturers of consumer devices (as opposed to midstream component manufacturers), and of calculating compensation by using the entire value of an end device as the royalty base. They identify the exceptional circumstances when mandating licensing at the component level would increase welfare, and explain why basing royalties on the entire value of an end device benefits innovators, manufacturers, and consumers alike.
The task of balancing innovators’ incentives to create beneficial technology and manufacturers’ opportunities to apply that technology in products and components at reasonable prices is complex and challenging. A large body of literature on the economics of innovation teaches us that reducing innovators’ return on investment lowers their incentive to innovate. Even so, determining when a reduction would decrease incentives (and by how much) is incredibly difficult, if not impossible. The complexity of this balancing exercise increases in multi-layered vertical industries, such as wireless communication, where (upstream) patent owners, (midstream) component manufacturers and (downstream) end-product manufacturers coexist
Some have complained that licencing arrangements get this balance wrong. In particular, they argue that common practices – licensing patents to downstream manufacturers (as opposed to component manufacturers) and using the entire value of an consumer device as the royalty base for compensation – substantially foreclose competition between midstream manufacturers and may allow patent holders to set excessively high royalty rates downstream.
In this paper, authors Jorge Padilla and Koren W. Wong-Ervin review these concerns and consider whether the proposed interventions – mandating licensing at component level and/or requiring royalties to be calculated using the value of the component as the royalty base – are justified on welfare grounds. They find that, other than in exceptional circumstances, such interventions would likely undermine investment incentives without reducing consumer prices and, therefore, harm the interests of all market participants – patent-owners, manufacturers, and consumers alike.