Decreasing Returns, Patent Licensing and Price-Reducing Taxes

In industries where a patent system is in place, licensing agreements among competing firms often create distortions, as they involve royalties. Royalties are generally considered to be anti-competitive as they raise market prices and reduce consumer welfare. In this paper we propose simple tax policies that can alleviate these effects. We consider industries where firms produce under decreasing returns and trade a patented technology. We first show that the interaction of royalty rates with decreasing returns can generate the counter-intuitive result that market prices decrease in the magnitude of diseconomies of scale. Using this result, we construct quantity tax schemes that lower prices and raise consumer surplus. Via these taxes the government collects sufficient revenue to compensate firms for their losses, without incurring any public deficit. Thus our schemes strictly Pareto improve the welfare of all agents