Licensing vs. Litigation: The Effect of the Legal System on Incentives to Innovate

With uncertain scope of patent protection and imperfect enforcement, the effective strength of patent protection is determined by the legal system. We analyze how the legal system affects the incentives of firms to innovate, taking into account possibilities of strategic licensing and litigation to deter imitation. The legal system that guarantees the patentee’s monopoly power maximizes the R&D intensities. However, the legal system that induces licensing provides incentives to exert R&D effort while preserving ex post efficiency. We also compare R&D, patent licensing, and litigation behavior under American and English rules of legal cost allocation.