Incumbency and R&D Incentives : Licensing the Gale of Creative Destruction

We analyze the relationship between incumbency and innovative activity in the context of a model of technological competition in which successful entrants are able to license their innovation to (or be acquired by) an incumbent. That such a sale ought to take place is natural since the post-innovation monopoly profits are greater than the sum of duopoly profits. The possibility of licensing leads to four key results. First, the unique equilibrium involves a technologically successful entrant licensing their innovation to the incumbent rather than entering the product market. Second, when intellectual property rights are weak, incumbents invest in R&D to achieve a strong bargaining position with technologically successful entrants. Third, incumbents research more intensively than entrants as long as (and only if) their "willingness-to-pay" for the innovation exceeds that of the entrant. Relative research intensity is unrelated to the pre-emption motives that were the primary concern of the previous literature. Finally, while the entrant always increases its research intensity in response to an increase in the incumbent's research intensity (strategic complementarity), the incumbent's response to an increase in entrant R&D depends on whether incremental rival research represents a positive or negative externality; when the incumbent's payoffs increase in the level of entrant R&D (as would occur when the licensing fee is relatively low), the incumbent considers entrant R&D an imperfect substitute for in-house research (resulting in strategic substitutability)