This paper studies royalty negotiations between a patent holder and a downstream firm selling a product which is more valuable if it includes a feature covered by the patent. Royalties are negotiated in the shadow of patent litigation, which will determine whether or not the patent is valid and infringed. If the two firms negotiate after the downstream firm has already designed its product to include the patented feature, the negotiated royalty rate exceeds the natural, normative benchmark level due to the patent holder’s ability, if the patent is found valid and infringed, to obtain a permanent injunction preventing the downstream firm from selling its product until it can introduce a non-infringing version. Royalty over-charges are greatest for weak patents covering minor features of products sold at prices well above marginal cost. The downstream firm’s ability to develop a non-infringing version of its product during the pendency of litigation can reduce but not eliminate these royalty over-charges. Royalty over-charges persist even if negotiations occur before the downstream firm designs its product. Indeed, for weak patents, the downstream firm gets no benefit from the ability to negotiate a license before designing its product. However, royalty over-charges are reduced if the courts stay injunctions to provide time for infringing firms to design non-infringing versions of their products.
