International licensing under an endogenous tariff in vertically-related markets

We construct a trading framework involving vertically-related markets to examine the foreign licensor’s optimal licensing contract, the optimal tariff, and the welfare difference between licensing and no technology transfer, in which a foreign vertically-integrated firm has a cost-reducing technology for the downstream product competing against host upstream and downstream firms in host markets. We obtain the following interesting results. First, international licensing lowers the welfare of the host country under non-drastic innovation, while the reverse occurs under drastic innovation. Second, the foreign licensor will choose royalty licensing with an optimal royalty rate higher than the innovation size if the innovation size is small, while selecting mixed licensing otherwise. Third, the optimal tariff rises, is followed by a vertical jump, and then falls (the optimal royalty rate increases, is followed by a vertical drop, and then continues to increase), when the innovation size becomes larger under non-drastic innovation.