Technological advancements have redefined the relationship between upstream and downstream firms, extending their collaboration beyond traditional supply chain dynamics. Upstream manufacturers are no longer just suppliers of intermediate inputs; they have become facilitators of technology transfer along the supply chain. This evolution raises concerns about anti-competitive conduct from upstream monopolies, which could potentially hinder the R&D efforts of downstream firms.

ACI’s research focuses on a specific type of anti-competitive behavior: reverse licensing. In this arrangement, the upstream monopoly uses its dominant position in supplying intermediate goods to compel downstream partners to share their technological innovations with competitors. For instance, before 2015, the dominant smartphone chips supplier, Qualcomm, required downstream Chinese producers like Huawei to voluntarily give up their patents without compensation (i.e., without offsetting royalties), when purchasing chips. This enables less efficient smartphone manufacturers, such as Xiaomi, to obtain both Qualcomm’s chips and Huawei’s complementary patents. In 2015, Qualcomm was ruled to be violating the anti-trust conduct by Chinese authorities.

The authors study the implications of reverse licensing through a multi-stage, game-theoretic model. In the first stage, the upstream dominant firm sets a retail price for the intermediate input. Next, downstream producers independently decide whether to invest in costly R&D. Because downstream firms vary in productive efficiency, their R&D decisions will differ. In the third stage, the upstream monopolist and downstream innovators decide whether to sign a reverse licensing agreement, allowing non-innovating downstream firms to adopt the innovation and save on production costs. If an agreement is reached, all downstream firms can adopt the innovation.

From the perspective of the upstream monopoly, reverse licensing is advantageous. When less efficient downstream firms adopt the innovation and reduce their production costs, they expand production, leading to higher derivative demand for intermediates supplied by the upstream monopoly. This increases the profit margin of the upstream firm.

In contrast, from the perspective of downstream firms, reverse licensing tends to suppress innovation. More efficient firms are discouraged from conducting R&D because allowing less efficient firms to free ride on their patents reduces their market share and undermines the return on their R&D investments. Inefficient firms, benefiting from the reverse licensing agreement, lack the incentive to invest in R&D as they can rely on the innovations of their peers. Consequently, incentives for R&D are diminished among all downstream firms.

To address the negative effects on innovation and monopolist pricing, the authors argue that antitrust authorities should require upstream firms to pay offsetting royalty fees for the technologies purchased from their downstream suppliers. This would provide downstream innovators with compensation for their R&D efforts and thereby improve their incentives. The authors cite a recent example in China to support their theoretical recommendations: Qualcomm is now required to pay royalties to its Chinese downstream firms to use their patents.

In summary, ACI’s research highlights the detrimental impact of reverse licensing on innovation within downstream firms. By leveraging their dominant position, upstream monopolists can force downstream partners to share their technological innovations, thus stifling R&D efforts. The proposed solution of requiring upstream firms to pay royalty fees for the technologies acquired from downstream innovators offers a viable way to mitigate these negative effects and encourage continued innovation. This approach not only compensates the innovators but also ensures a more competitive, dynamic, and healthy ecosystem.

By HUANG, Yijia

Researchers: KO, Chiu Yu, SHEN, Bo, ZHANG, Xuyao