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Network Effects and Technology Licensing

Information technology innovations that lead to new products/services exhibiting network effects form an increasingly important driver of economic growth. A paramount question faced by such innovators is whether to offer the innovation to other firms that compete with them in the same market. In this paper, we consider a firm’s licensing choice in presence of network effects. The economics literature has found that producer-innovators should use royalties instead of fixed fees when licensing. We find, however, that as the intensity of the network effect increases, the choice of licensing mechanism shifts from a royalty-based regime to a fee-based regime. Furthermore, in each regime, the optimal royalty rate or the optimal fee is influenced by the intensity of the network effect, the investment needed to replicate the innovation, and the size of the potential market. Our results provide valuable insights in formulating licensing decisions in industries that exhibit network effects.