NEW PRODUCT LICENSING: Why do companies license their IP? Feryal Erhun Enis Kayis Management Science and Engineering Stanford University Mark Wilkinson Intel Corporation MSOM Conference 2005

The Transformation of the Computer Industry (80’s and 90’s) Sales and distribution Application software Operating system Computer Chips IBM DEC Sperry Univac Wang Sales and distribution Application software Operating system Computer Chips Intel Architecture DOS and Windows Word Perfect Etc. OS/2 Mac UNIX Dell Compaq Packard Bell HP IBM Superstores Retail Stores Dealers Mail Order Motorola Source: A.S. Grove (1999) Only The Paranoid Survive: How to Exploit the Crisis Points That Challenge Every Company, Currency-Doubleday, New York, NY. 2

Motivation: The Tale of Three Companies (The Story of IBM, Intel, and AMD) IBM adopted x86 chips for its first computers in 1982 As part of the deal, Intel had to license the x86 architecture to AMD so that IBM could have a second source of chips Intel, as a new player in the arena, did not have enough capacity to satisfy all the demand and needed the extra respectability that second sourcing provides Licensing helped Intel by encouraging other producers to push the Intel product while discouraging their own future generations of chips Source: http://www.redhill.net.au/c-amd.html 3

Motivation: Moving R&D to High Volume (R&D Labs) Lack of production capacity to produce output at a level necessary to satisfy total market demand Manufacturing costs at R&D facilities are usually higher than at high-volume manufacturing facilities Outsource/license the product to reach a bigger market at lower costs 4

Research Questions Why/when would a company license its intellectual property (IP)? What is the role of an inventor’s capacity in the market equilibrium? What is the role of manufacturing cost in product licensing? 5

Agenda Model Definition Analysis of the Model Conclusion 6

Model Definition-I CS OEM CS2 End consumers Price p Wholesale price, Literature Review Model Definition Analysis of the Model Extensions Conclusion 7

Outsource the production to CS2 License the component to CS2 Model Definition-II CS2 OEM CS Wholesale price, w1 End consumers Price p CS2 OEM CS Wholesale price, w1 End consumers Price p Royalty Fee, α Wholesale price, w2 Outsource the production to CS2 Transfer Price, t2 License the component to CS2 Literature Review Model Definition Analysis of the Model Extensions Conclusion 8

Modeling Demand CS develops a component, which will be embedded within OEM’s new product The potential number of customers attracted by OEM’s product is N The probability that any customer purchases OEM’s product at price p with price sensitivity b is: The aggregate demand is therefore: Literature Review Model Definition Analysis of the Model Extensions Conclusion 9

Modeling Supply CS may produce her proprietary component at unit production cost c and sell it to OEM at a wholesale price w1 CS has limited production capacity K CS can subcontract the production to CS2, who has “virtually unlimited capacity” and lower production cost c Literature Review Model Definition Analysis of the Model Extensions Conclusion 10

Agenda Model Definition Analysis of the Model Licensing Conclusion 11

Analysis Case III Case II Case I NO YES NO YES Produce capacity, LICENSING Analysis License the product? NO YES Participate in production? NO YES Case II Produce all (D,0) Condition: D<K Case I License all (0,D) Case III Produce capacity, license the rest (K,D-K) Condition: D>K Literature Review Model Definition Analysis of the Model Extensions Conclusion 12

LICENSING Results CASE II (D,0) CASE I (0,D) CASE III (K,D-K) 13

Summary of the Results - Licensing Royalty fee is independent of CS’s capacity It depends only on price sensitivity and CS2’s cost Even when CS has “virtually unlimited capacity,” she may still want to license When the capacity is limited, licensing creates competition for CS2 CS2 produces more than he wants More capacity is not always good for CS Literature Review Model Definition Analysis of the Model Extensions Conclusion 14

Agenda Model Definition Analysis of the Model Licensing Outsourcing Conclusion 15

Analysis Similar to licensing contracts, three cases to analyze: OUTSOURCING Analysis Similar to licensing contracts, three cases to analyze: CASE A: CS2 sets transfer price t2<c, hence CS outsource all her production - (0,D) CASE B: CS2 sets transfer price t2=c, hence CS is indifferent between in-house production and outsourcing - (0,D) CASE C: CS2 sets transfer price t2>c, hence CS outsource the residual demand – (K, D-K) Literature Review Model Definition Analysis of the Model Extensions Conclusion 16

Results CASE B CASE A (0,D) (0,D) CASE C (K,D-K) OUTSOURCING Literature Review Model Definition Analysis of the Model Extensions Conclusion 17

Summary of the Results - Outsourcing CS2 has “virtually” moved up in the supply chain Hence it is: Driving the supply chain Getting most out of the relation Always participates in production CS’s capacity can be used strategically when she does not have “virtually unlimited capacity” CS does not participate in production even if she has too much capacity Literature Review Model Definition Analysis of the Model Extensions Conclusion 18

Agenda Model Definition Analysis of the Model Licensing Outsourcing Comparison Conclusion 19

Licensing vs. Outsourcing (CS’s profit) Licensing is weakly preferred for almost all of the K-c region: Better outcome is sustainable with licensing Royalty fee is higher than profit margin from outsourcing Literature Review Model Definition Analysis of the Model Extensions Conclusion 20

Conclusion Licensing is a reasonable alternative to outsourcing for a low cost, under-capacity supplier Capacity can be used strategically by both suppliers to achieve higher profits, especially when CS’s capacity is low Even when building capacity is free, it is not always in CS’s best interest to increase her capacity, especially when her supply chain partners know her exact capacity CS does not always produce more when her capacity increases Literature Review Model Definition Analysis of the Model Extensions Conclusion 21

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