Strategic technology commercialization in the supply chain under network effects

Highlights

• Free licensing may benefit the innovator in a supply chain with network effects.

• The innovator and the supplier may prefer different commercialization strategies.

• The supplier can partially control commercialization strategies of the innovator.

• The choice of licensing contracts depends on network effects and product quality.

• The findings are relatively robust with respect to the upstream market structure.

Abstract

We explore the optimal technology commercialization strategy of an inside innovator in the downstream of a two-tier supply chain when network effects exist via a game-theoretical framework. This setting incorporates in a unified model the two strategic incentives for the innovator to license to potential competitors for free, i.e., expanding the network size and driving down the wholesale price, thus it enables us to disclose how these two incentives interact with each other to influence the innovator's choice between the internal and external commercialization strategies. Our analyses reveal several interesting results. First, it is beneficial for the innovator to license to the entrant, even for free, when the relative quality of the low-end product provided by the latter is moderate. Second, when the network effects are weak and the quality of the low-end product to introduce is high, the innovator prefers the internal commercialization strategies, while the supplier and the consumers prefer the external commercialization strategy. Third, if licensing fees can be collected, the fixed-fee licensing contract dominates the royalty licensing contract when network effects are strong, or when the entrant is relatively weak. In addition, in the extended models, we point out that our key findings and insights are relatively robust with respect to the market structure in the upstream of the supply chain (monopolistic versus competitive) or the cost structure of the differentiated final products (homogeneous or heterogeneous), but they are somewhat different under alternative wholesale price mechanisms (uniform versus discriminatory).

Introduction

Technology commercialization strategy is vital for innovative firms, especially when they are inside innovators who are not only technology providers but also producers of the final products (Poddar and Sinha, 2004). It is not uncommon that the inside innovators proactively license their technologies to potential competitors in the final product markets (i.e., the external commercialization strategy), sometimes even for free, although restricting the use of these technologies within the firms (i.e., the internal commercialization strategy) may help them avoid competition in the final product market. This phenomenon is more pervasive in markets with network effects, where the value of the product to each consumer increases in the network size, i.e., the number of users that adopt the same or compatible products (Farrell and Saloner, 1985; Katz and Shapiro, 1985). For example, Microsoft, as the innovator of Windows operation systems, not only launches its own laptop Surface Book based on Windows, but also licenses its operation system to other competitive enterprises (such as Lenovo, Dell, HP, etc.) to develop laptops. Another classical example is from the electric vehicle industry where network effects also play a vital role. Tesla, as a leading innovator in this industry, declares to open all its patents on electric vehicles to competitors for free. By licensing or sharing technologies to potential competitors that can offer differentiated but compatible products, the innovators might be able to establish a larger network size and thus enhance the value of their own products to consumers (Conner, 1995; Economides, 1996; Kim, 2002; Sun et al., 2004; etc.). However, the presence of network effects is not the only possible explanation for the inside innovator to adopt the external commercialization strategy.

Another strategic incentive for the inside innovator to adopt the external commercialization strategy might arise from the supply chain structure it lies in. In the literature on technology licensing without consideration of network effects, it is a well-established finding that the innovator can induce the upstream suppliers to offer more favorable wholesale prices by licensing to competitors, especially when the input market is relatively concentrated (Arya and Mittendorf, 2006; Chen et al., 2016). This viewpoint might also partially explain the licensing behaviors of the inside innovators in industries with network effects like the laptop or electric vehicle industries, because the supply of core components in these industries is usually dominated by one or a few main suppliers. For example, in the laptop industry, many core components like CPU, LED screen are supplied by one or a few common suppliers; similarly, in the electric vehicle industry, the provision of batteries is controlled by a few large companies like Panasonic. Because of the existence of these key suppliers in the upstream of the supply chain, it is vital for the downstream innovators like Microsoft and Tesla to consider the possible impacts of licensing on the wholesale prices when determining whether to license to the competitor or not.

Although there are some researchers trying to explain the innovator's licensing behavior from the presence of network effects (Conner, 1995; Economides, 1996; Kim, 2002; Sun et al., 2004; etc.), or from the influence on input prices (Arya and Mittendorf, 2006; Chen et al., 2016) separately, there is no work that incorporates the two possible strategic motivations in an integrated model, thus the interactions between them and the impacts of these interactions on the innovator's strategy are still very vague. This stimulates us to investigate the following questions in this paper: (a) How should an innovator in the downstream of a supply chain choose between internal and external commercialization strategies when network effects present? (b) How do the strategic incentive of expanding network size and that of reducing input prices interact with each other to influence the innovator's choice of commercialization strategies? (c) If licensing fees can be collected under the external commercialization strategy, what is the optimal form of licensing contract for the innovator, a fixed-fee or a royalty? (d) Does the supplier's wholesale price mechanism (uniform wholesale price versus discriminatory wholesale prices), or the structure of the input market (a monopolized supplier versus two competitive suppliers) influence the innovator's choice of commercialization strategies?

To address these questions, we consider a two-tier supply chain under network effects in the basic model, which consists of an innovator and a potential entrant in the downstream, as well as a common supplier in the upstream who provides the critical component to the downstream firms at a uniform wholesale price. We explore the innovator's optimal commercialization strategy in both cases when the licensing fee is absent and when it is collected in game-theoretical frameworks. By solving the games via backward induction, we obtain closed-form solutions to the optimal technology commercialization strategy for the innovator. We also find that the supplier can partially control the commercialization strategy of the innovator through the wholesale price, and he accommodates quite different types of low-end product under the product line strategy and the free licensing strategy. In addition, we check the robustness of our main findings obtained in the basic model by considering the scenarios with discriminatory wholesale prices, with competitive suppliers, as well as with heterogenous marginal costs for differentiated products in the extension section. This study, to the best of our knowledge, is the first one to incorporate in a unified model these two possible strategic incentives for the innovator to license to a potential entrant for free, including expanding the network size and driving down the wholesale price. This model setting enables us to disclose how these two incentives interact with each other to influence the innovator's choice between the internal and external commercialization strategies. The findings can supplement and enrich the theoretical framework of technology licensing in both fields of network economics and supply chain management, and guide the technology commercialization practices of inside innovators in industries characterized with network effects and highly concentrated input markets.

The rest of the paper is organized as follows. Section 2 reviews the related literature. Section 3 presents the model and analyzes the consumer's purchasing decisions to depict the demand functions in the final product market. In the basic scenario where a common supplier offers a uniform wholesale price to downstream firms, the optimal commercialization strategy for the innovator when licensing fees are absent is analyzed in Section 4, while that when licensing fees are collected is explored in Section 5. In Section 6, three extension scenarios, i.e., the discriminatory wholesale price scenario, the competitive supplier scenario, and the heterogenous marginal cost scenario, are examined in order to check the robustness of our results. We conclude the paper in Section 7 by discussing the main findings and suggesting directions for future research.