A simple model is developed to study royalty negotiations between a patent holder and a downstream firm whose product is more valuable if it includes a feature covered by the patent. The downstream firm must make specific investments to develop, design, and sell its product before patent validity and infringement will be determined. The hold-up component of the negotiated royalties is greatest for weak patents covering a minor feature of a product with a high margin between price and marginal cost. For weak patents, the hold-up component of negotiated royalties remains unchanged even if negotiations take place before the downstream firm designs its product. The analysis has implications for the use of injunctions in patent infringement cases.
Binmore, Ken, Avner Shaked, and John Sutton. 1989. “An Outside Option Experiment,” 104(4) Quarterly Journal of Economics 4753–70. link to PDF.
Elhauge, Einer. 2008. “Do Patent Holdup and Royalty Stacking Lead to Systematically Excessive Royalties?” 4(3) Journal of Competition Law and Economics 3535–70.
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Lemley, Mark, and Carl Shapiro. 2007a. “Patent Hold-Up and Royalty Stacking,” 85(7) Texas Law Review 71991–2049. Available at: http://faculty.haas.berkeley.edu/shapiro/stacking.pdf. (see also Patent Hold-Up and Royalty Stacking: Reply)
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