Patent licensing in spatial competition: Does pre-innovation cost asymmetry matter?

We consider the optimal licensing strategy of an insider patentee in a circular city of Salop’s model and in a linear city of Hotelling’s model when firms have asymmetric pre-innovation marginal costs of production and compete in prices. We completely characterize the optimal licensing policies using a fixed fee and per-unit royalty under the drastic and non-drastic innovations. We find that when the innovative firm is efficient compared to the licensee at the pre-innovation stage then the results regarding optimal licensing policy coincide with the results described in the literature with symmetric firms. However, this is not true when the innovative firm is inefficient in the pre-innovation stage compared to the licensee. To that end, we show that even a drastic innovation can be licensed using a royalty scheme when the patentee is highly inefficient compared to licensee in the pre-innovation stage and the size of the innovation is intermediate. We also show that in this set-up, fixed fee licensing is never optimal.