Ex-ante licensing in sequential innovations

The theoretical literature on the cumulative innovation process has emphasized the role of ex-ante licensing – namely, licensing agreements negotiated before the follow-on innovator has sunk its R&D investment – in mitigating the risk of hold-up of future innovations. In this paper, we consider a patent-holder and a follow-on innovator bargaining over the licensing terms in a context where the former firm is unable to observe the timing of the R&D investment of the latter. We show that the possibilities of restoring the R&D incentives by setting the licensing terms appropriately are severely limited.