The Relevance of Bargaining for the Licensing of a Cost‐reducing Innovation*

In the context of a Cournot duopoly, this paper studies the licensing of a cost‐reducing innovation by means of three possible allocation mechanisms: auction, fixed fee, and direct negotiation. Once the use of an arbitrary reserve price (which is not credible) has been excluded, it is no longer true that auction always yields higher profit to the patentee than a fixed fee. However, the authors propose a direct negotiation mechanism which restores the patentee's profit to the level of an auction with an arbitrary reserve price (which is unimplementable). Direct negotiation is superior to both an auction with a nonarbitrary reserve price and a fixed fee. From the social point of view, however, licensing with a fixed fee is the best option.