JOURNALOF

EconomicEkhavior
Journal of Economic Behavior and Organization & Organization
EISEVIER Vol. 28 (1995) 63-78

Moral hazard and optimal contract form for

R&D cooperation
Karl Morasch *
Wirtschafis- und Sozialwissenschaftliche Fakultiit, Universitiit Augsburg, D-86135 Augsburg, Germany

Received 25 March 1993; revised 29 August 1994

Abstract

This paper aims to explain the use of different governance modes for R&D cooperation.
We argue that (ex ante) cross-licensing agreements are preferred to R&D joint ventures if
potential synergy effects are negligible and the double moral hazard problem caused by
unobservable R&D effort can be solved by an appropriate royalty scheme. It is shown that
the first best effort decisions are implementable by a cross-licensing agreement if royalty
payments are based on R&D success. However, if the payments have to be based on actual
know-how transfer because R&D success is not verifiable, there are cases where joint
ventures are necessary to induce optimal R&D effort.

JEL classification: D23; D82; L22; 032

Keywords: R&D cooperation; Contract form; Moral hazard

1. Introduction

R&D cooperation is very common in R&D intensive markets. It is used to

reduce the risk of failure in R&D competition, to gain access to specific
knowledge when undertaking complex research projects, to avoid duplication of
research effort, to internalize R&D spillovers and to overcome cost-of-develop
ment barriers. However, there are not only different reasons for R&D cooperation

* Corresponding author. Tel. (0821) 598-4196, Fax (0821) 598-4230

0167-2681/95/$09.50 6 1995 Elsevier Science B.V. All rights reserved

SSDZO167-2681(95)00020-8
64 K. Morasch/J. of EconomicBehavior& Org. 28 (1995) 63-78

but also different governance modes to organize cooperative research. Following

Diittmann (1989) two broad categories of contract forms for R&D cooperation
can be distinguished:
1. With an (ex ante) cross-licensing agreement ’ each firm does research work on
its own. The contract only specifies how the subsequent results will be shared.
2. In contrast an R&D joint venture calls for a common research strategy.
Usually a separate entity is created to carry out the research work.
How common are these different forms of agreements? An inquiry by Rotering
(1990, p. 117) reports that about 75% of all R&D cooperation in Germany is
based on (ex ante) cross-licensing agreements or similar contract forms, while
joint ventures are used in about 25% of all cases. From data on about 4000
world-wide cooperative agreements (not all, however, related to R&D) reported in
Hagedoorn (1990) similar results are obtained: For the period from 1985 to 1988
there are 1163 cooperative agreements in this data set which are concerned with
joint R&D and technology exchange. The joint venture form is used in about 30%
of all cases while 70% of the R&D cooperation is based on “joint R&D and
technology exchange agreements”. Our paper aims to explain why firms use
cross-licensing agreements in some situations and joint ventures in others.
Many empirical studies have been done on inter-firm cooperation, but with the
exception of Osborn and Baughn (1993) they do not provide an analysis of the
factors underlying the choice of the appropriate governance mode. The study by
Osbom and Baughn is based on data about cooperative agreements between U.S.
and Japanes firms (not necessarily concerned with joint R&D). They analyze
technological factors and their basic result is that high technological intensity of an
industry favors contractual arrangements (because they are more flexible) while
the intention to conduct joint R&D makes joint ventures more attractive (because
they facilitate the realization of synergy effects and are a means to avoid
opportunistic behavior). In our paper we will concentrate on the last aspect: Based
on a theoretical model we discuss whether the joint venture form is indeed
necessary to avoid opportunism.
From a theoretical perspective there are basically two factors which determine
the appropriate governance mode for R&D cooperation: Synergy effects and
transaction costs. To realize synergy effects, joint R&D is necessary. We focus on
situations where synergy effects are negligible and therefore only transaction cost
considerations are relevant. Joint ventures call for more complex contracts and for
reorganization to make joint R&D possible. In this respect cross-licensing agree-
ments would be preferable. On the other hand “behavioral uncertainty” [see

1
The term is used in a broad sense: “ Licensing” refers to all forms of know-how-transfer not only
to the right to use a patented technology. To use the term in this way is common in the theoretical
literature [e.g. Katz (1986)], while in empirical studies, terms like “joint R&D and technology
exchange agreements” [Hagedoom (1990)] are used to describe the same types of agreement.
 K. Morasch / J. of Economic Behavior & Org. 28 (I 995) 63-78 65

Williamson (1989)] may be a problem: Firms cooperating in R&D face a double

moral hazard problem, because with R&D effort not being observable each
partner will focus on its own profit when choosing its effort level. In this context a
joint venture can serve as a means to make R&D effort observable - the moral
hazard problem is solved by monitoring. In a cross-licensing agreement, however,
the incentives must be modified by an appropriate royalty scheme 2. With an
optimal royalty scheme, the R&D effort which maximizes each partners own
profit also maximizes joint profits. If an optimal royalty scheme is feasible, the
cross-licensing agreement is preferable to an R&D joint venture because of
otherwise lower transaction costs.
While in reality cross-licensing arrangements often entail zero licence-fees (for
reasons see section 4), there are examples of R&D cooperation where firms use
payments which are based on know-how-transfer [see e.g. Diittmann (1989, pp.
302 f.)] or R&D success [see Lewis (1990, p. 98)] in order to give appropriate
incentives for investments in R&D. It is also very common to use other, more
indirect ways to reduce opportunism by changing incentives - e.g. cross share-
holding [see Lewis (1990, p. 115)]. The question of our paper may therefore be
expressed in a more general way: In which situations is it possible to solve the
moral hazard problem of R&D cooperation by changing the incentive structure
via an appropriately designed contract, and when, on the contrary, is it necessary
to ensure monitoring of effort decisions by a joint venture? In order to answer this
question we will analyze different situations, where in principle both contract
forms may be suitable.
Both joint ventures and cross-licensing agreements can be used for organiza-
tional reasons in the following cases 3, which will be dealt with in this paper: (i)
The firms are active in the same fields of research (“parallel research”) and
synergy effects of joint research are negligible. Here cooperation is used to reduce
the risk of failure in R&D competition. Cooperating firms follow independent
research strategies and the results will be shared ex post. This situation is
prevalent in, for example, the pharmaceutical industry [see Porter and Fuller
(1986)]. (ii) Each partner has special knowledge and competence in distinct parts
of a research project (“specialization”). Then each firm specializes in this distinct
part and results are shared ex post. R&D in the aircraft industry and the
development of high-tech military equipment are examples of this case [see
Rotering (1990, p. 116)].
In this paper we try to isolate the situations in which a cross-licensing

*As with “licensing” the terms “royalty” and “licence fee” are used in a broad sense: To modify
incentives, the contract specifies transfer payments between the cooperating firms, which depend on
R&D success or actual know-how-transfer.
3 Here a joint venture is used solely to facilitate the monitoring of R&D efforts in order to solve the
moral hazard problem - the organization of research will not be different than in a cross-licensing
agreement.
66 K. Morasch / J. of Economic Behavior & Org. 28 (1995) 63-78

agreement with an appropriate royalty scheme can solve the moral hazard problem
and therefore will maximize joint profits. The problem of moral hazard in teams
has already been addressed in the literature: Holmstriim (1982) has shown that
optimal effort cannot be induced with budget balance if only joint output is
observable. However, Gandal and Scotchmer (1993) show in a patent race setting
with two firms that the moral hazard problem of R&D cooperation can be solved:
The date of discovery and the identity of the discoverer give two signals. We
assume that the partners can observe whether the other firm has been successful -
this resembles the situation of Gandal and Scotchmer (1993) insofar as there are
two signals. However, in contrast to them we will analyze situations which do not
necessarily involve a patentable innovation and where, therefore, verifiability of
R&D success may be a problem. In these cases the transfer payments (licence
fees) have to be based on another, verifiable signal: actual know-how-transfer. We
will discuss how the unverifiability of R&D success may influence the feasibility
of an optimal royalty scheme for three different specifications of R&D competi-
tion.
The paper is organized as follows: Section 2 describes the model and the
optimal royalty scheme is derived. Section 3 starts with an economic interpretation
of the results. Subsequently it is argued that the royalty scheme has to be incentive
compatible ex post. Finally we report the results of a numerical simulation which
deals with the difference between first best and second best outcomes if the first
best royalty scheme is not feasible. In section 4 we give a summary of the basic
results and discuss how these results will be changed if we relax some simplifying
assumptions of our model.

2. The model

In subsection 2.1, the assumptions concerning R&D competition are presented

and joint profit maximization is derived as a reference solution and compared with
private optimization. In subsection 2.2, different forms of cross-licensing agree-
ments (with verifiable and unverifiable R&D success) are incorporated into the
model. The optimal royalty schemes are derived as a subgame-perfect Nash
equilibrium of the resulting multi-stage game in subsection 2.3.

2.1. R&D technology and optimal R&D effort

There are two firms F, and F2 which are active in independent product
markets. This ensures that the royalty scheme is designed to solve the moral
hazard problem only and not in order to influence the competition in the product
market: In the terminology of Katz and Ordover (1990) we abstract from “compe-
titive spillovers”. Effects of competitive spillovers on the choice of the optimal
contract form will be discussed at the end of the paper.
 K. Morasch /J. of Economic Behavior & Org. 28 (I 995) 63-78 67

R&D success Pi is stochastic and depends on one’s own R&D effort ei

(measured in terms of money), but not on the R&D effort ej of the other firm -
there are no “technological spillovers”, even if there is joint research. Higher
R&D effort raises the probability of success, however, with diminishing returns.
Formally the relationship between effort and probability of success can be
described in the following way:
P,(O) = 0, lim Pi = 1, P,‘> 0, P: < 0 (1)
ei-+m

If the two firms cooperate, the probability of R&D success is given by

P, + P2 -PI P2 in the case of parallel research and by P, Pz in the case of
specialization.
Let ui be the present value of the successful innovation gross of R&D costs e,.
The firms are assumed to be risk neutral and therefore maximize the expected
value of net profits Vi. R&D cooperation aims at maximizing the sum of expected
profits V, + V, 4. The objective functions in the case of parallel research and in
the case of specialization are given by the following equations:
VI+V2 = (uI+u2)(P1+P2-P1P2)-(e,+e,) (2)
VI + V, = (q + u2)P,P2 - (el + e2) (3)
The resulting first order conditions are:

a(& + V*)
= (I+ + ur)(l - Pj)P,’ - 1= 0
aei
a(5 + v,)
aei
= (ul+u*)PjP;-l=o (5)
P; < 0 and P,e]O,l[ assure that the solution is not a minimum (this holds for all
subsequent optimization problems). The assumptions in Cl), however, cannot
guarantee that the second order conditions for a maximum are always fulfilled.
Further on it will be assumed that second order conditions are met (the results of
the numerical simulation meet the second order conditions).
If the firms use a cross-licensing agreement, the partner’s R&D effort is not
observable and each firm will maximize its own profits instead of joint profits.
With a royalty-free cross-licensing agreement we get:
y = q(P,+P,-PIP,)-ei (6)
y = uiP,P2 - ei (7)

4 Because this sum always exceeds the sum of expected profits which result from private optimiza-
tion, lump-sum payments can ensure profitability of cooperation for each participating fii.
68 K. Morasch / J. of Economic Behavior & Org. 28 (1995) 63-78

The resulting first order conditions are:

- = Uj(l - Pj)Pi - 1 = 0
aei
av,
- = vipjp; - 1 = 0
dei

Comparing Eqs. (8) and (9) with the first order conditions for joint profit
maximization given by (4) and (5), it can be shown that a royalty-free cross-licens-
ing agreement results in suboptimal R&D effort. This is due to the double moral
hazard problem: Because R&D effort is not observed by the partner, each firm
chooses the privately optimal effort level and does not consider the positive
externality on the other firm.

2.2. Transaction technology and contract design

To maximize the sum of expected profits, it must be assured that both firms
choose the optimal R&D effort according to (4) and (5) respectively. As stated in
the introduction, two contract forms may be distinguished: The firms could either
form a joint venture, where the R&D effort will be chosen cooperatively, or sign
an (ex ante) cross-licensing agreement, where the conditions of a subsequent
know-how transfer and the royalty scheme are fixed but the firms would still
decide independently on their R&D effort.
With respect to the pattern of transaction costs the two contract forms differ in
the following way: A joint venture requires a relatively complex contract, defining
explicitly the rights of the partners in many contingencies. Monitoring R&D
inputs calls for joint R&D facilities, which induces extra costs as well. A
cross-licensing agreement is characterized by comparatively lower transaction
costs, because it is easier to describe the conditions of the know-how transfer and
the royalty scheme [the same argument is put forward by Buelt (1988)]. Therefore
a cross-licensing agreement is preferable if it guarantees that the firms choose the
optimal R&D effort 5. This paper analyzes under what conditions a royalty
scheme can shift the private incentives for R&D in order to maximize joint
profits.
It is assumed that the cross-licensing agreement uses fixed licence fees li 6.
Depending on the verifiability of R&D success, the fee is due either if the other

5 This is true only if the joint venture is solely used as a monitoring device to avoid the moral hazard
problem. If synergy effects exist or other reasons for using a joint research facility are present, a joint
venture may be preferable: In this case the gains of joint research have to be weighed against the higher
transaction costs.
’ This ensures that - in contrast to an output-based royalty - the royalty payment does not influence
the output decision of the licensee and therefore the expected gross returns ui remain unaffected.
 K. Morasch/J. of Economic Behavior & Org. 28 (1995) 63-78 69

firm has successfully finished R&D or if know-how actually is transferred. With

parallel research know-how is not transferred if both firms succeed, with special-
ization this is the case if only one fii succeeds. Under these conditions there will
be no royalty payments if the fees are based on actual know-how transfer. It is
possible to base the royalty scheme on R&D success if a third party (e.g. a court)
can easily observe whether a firm has been successful (R&D success is verifiable).
However, cost-reducing process innovations and results of basic research, which
must be combined with other knowledge to be usable, often lack this property. In
this instance fees based on actual know-how transfer have to be used instead.
Considering different R&D technologies as well as differences in verifiability
of R&D success, the following five situations can be distinguished 7:

(Bs) The firms are active in the same field of research. It is possible that both
firms successfully develop the new product or process (i.e. R&D success is
independent of the other firms effort). The licence fees are based on R&D
success.
(Bt) As in (Bs) there is parallel research with independent R&D success, but
licence fees have to be based on actual know-how transfer.
(R) As before, both firms are active in the same field of research, but now only
one firm can be successful, because R&D success results in an exclusive
patent (usually this situation is modeled as a “patent race”) 8.
(SS) The firms specialize in different fields of research and R&D results need to
be combined to be economically useful. Royalty payments are based on
R & D success.
(St) Again there is specialization, but now payments have to be based on actual
know-how transfer.

Given this, we obtain the following objective functions:

(BS)v, = ~;(P1+P,-P,P,)+fiPj-IiPj-ei (IO)
(Bt)Vi=Vi(P1+P~-P~P*)+1iPi(l_Pi)-ljPj(l_Pi)-ei (11)

(R)v = Ui(P, +Pz-P*Pz) +E,PI(l-~~)-I,~(l-~~j)-ei (l2)

(SS) y = viP,P2 + liPi - liPj - ei (13)

(St) l$ = uiP,Pz + (Zi - Ij)PIP2 - e,

7 The letters in brackets are mnemonics with the following meanings: B stands for “both firms may
be successful”, R for “patent race”, S for “firms specialize”, s for “fees based on R&D success”,
and t for “fees based on know-how fransfer”.
8 With R&D competition of type (R) it makes no difference whether royalty payments are based on
R&D success or on actual know-how transfer: Only one fm can succeed in the patent race, which
always results in a know-how transfer.
70 K. Morasch /J. ofEconomic Behavior & Org. 28 (I 995) 63-78

The following considerations lead to Eq. (12): If, based on the realizations ofP,
and Pi, both firms are successful (the probability of this event is given by P,Pj),
we assume that each firm is equally likely to be the actual “winner” of the race.
While the timing of the innovation is not considered explicitly by this formulation,
we preferred it because it allows an analogical treatment of all specifications 9
Considering royalty payments, we obtain the following first order conditions for
private optimization:

(Bs)Z = [(IJi+li)-viPj]P;-l=o (15)

I

(IQ)2 = [(Vi+li)(l-Pj)+IjPj]P;-l=O
I

(R)Z = [(y(l-~)+zi(l-;P)+I,~P~]P;-l=O (17)

I
av,
(SS) z = (UiPj + li)Pi’ - 1 = 0
I

(St) de_ = (Ui + li - lj)PjP,’ - 1 = 0 (19)

1
In the next section optimal licence fees will be derived (if the first best is
attainable): These licence fees modify the partner’s private incentives in a way that
ensures the maximization of joint profits.

2.3. Optimal royalty scheme

To derive the optimal royalty scheme, the problem is modeled as a multi-stage

game:
Stage I: The partners cooperatively choose licence fees Ii lo. It is assumed that
the R&D success functions Pi and the expected gross profits ui are common
knowledge I’.

9 See Reinganum (1989) for a survey of the literature on the timing of innovations in patent races.
Gandal and Scotchmer (1993) analyze the moral hazard problem of R&D cooperation in a dynamic
patent race model.
r” Because licence fees are paid by one firm to the other, budget balance is implicitly assumed. To
satisfy ex ante participation constraints and to divide the gains from cooperation, the firms will use
lump-sum payments which do not affect incentives. Ex post participation constraints, which may limit
the range of feasible licence fees, are discussed in section 3.
l1 With private information about Pi or ui the firms would face an adverse selection problem. Gandal
and Scotchmer (19931, McAfee and McMillan (1991) and Picard and Rey (1990) analyze the design of
contracts in the presence of both moral hazard and adverse selection. In this case the efficient
(full-information) solution is not implementable.
 K. Morasch/J.- of EconomicBehauior& Org. 28 (1995)63-78 71

Table 1
Payoffs
Situation both successful only Fi successful

(Es) (Vi + Ii - li,Vj + 1, - Ii) (Vi + li,Uj - I J

(Br) (“iPuj) hi + li,Vj - Ii)

(R) not possible (Vi + l,,Uj - Ii)

6s) (u, + Ii - Ij,Vj + lj - Ii) (Ii, - Ii)
(St) (Ui + Ii - lj,Uj+ 1, - 1,) CO,O)

Stage 2: Each firm chooses its privately optimal R&D effort - the concept of
non-cooperative Nash equilibrium is used to analyze the interaction at this stage.
Stage 3: The R&D effort results in either R&D success or failure, which is
observed by both firms.
Stage 4: If applicable, the know-how is transferred as agreed - in the case of
(S) if both firms have been successful, otherwise, if only one firm has been
successful. Furthermore the contracted royalty payments are made.
The resulting gross payoffs l2 (without deducting the R&D effort) are given in
Table 1.
In this section it will be assumed that the firms reliably fulfill the contract at
stage 4 - incentives to deviate expost and the resulting consequences for contract
design will be discussed in section 3.2. Because stage 3 is a move by nature, firms
have to make decisions at stages I and 2 only. The problem will be solved by
using the concept of subgame-perfect Nash equilibrium.
At stage 2 the firms non-cooperatively choose their R&D efforts (e,, e,)
while taking the royalty scheme (1,, f,> as given. If the first order conditions
(lS)-(19) of both firms are simultaneously solved with respect to (e,, e2), we will
obtain the Nash equilibrium at stage 2 13.
Before choosing their R&D effort levels, the firms cooperatively choose a
royalty scheme (1,, I,) in order to induce the jointly optimal R&D effort levels
(el* ,e; > at stage 2. Given that the Nash equilibrium at stage 2 is unique for
optimal licence fees (1; ,l; 1, solutions can be derived by the following procedure:
We equate the first order conditions (15)-(M) for privately optimal R&D at
(e,,e,) = (e; ,e; ) with the corresponding first order conditions (4) and (5) for
jointly optimal R&D. This results in two equations with two unknowns which can
be solved with respect to (1,, 12). In the case of CBS), for example, we obtain the
following system of equations with Pi* = P,(ef ) and Pi * = P$ef ):
[@I + 4) - VIP; 1pi*-l=(ul+uz)(l-P;)P;* -1 (20)
[(% + 12) - %P; Ipi* -l=(q+U*)(l-P;)P~* -1 (21)

l2 The first expression in the bracket is the payoff of Fi, the second expression is the payoff of Fj.
l3 Existence of a Nash equilibrium in pure strategies with positive effort levels is assumed.
72 K. Morasch /J. of Economic Behavior & Org. 28 (1995) 63-78

A royalty scheme which solves the two equations ensures that the first order
conditions for privately optimal R&D are fulfilled at (e, ,e2) = (e; ,e; >. There-
fore the firms will choose jointly optimal R&D effort levels if the Nash
equilibrium at stage 2 is unique. The equations have unique solutions and we
obtain the following optimal licence fees:
(Bs) 1; = ?$(l -p,*) (22)
ViPi, - Vj( 1 - P,’ )
(W 1; = (1 -Pa p* +p,* _ 1 (23)
I I
Vi(l-Pi*)Pj* -Vj(2-Pi*)(1-pj*)
(R)l; = (24)
Pi’ + Pj’ - 2

(Ss) 1; = vjpi* (25)

Maximization of joint profits is not feasible in situation (St): There are no values
ofl, and lj such that firms’ effort choices coincide with the optimal effort levels.
This stems from the fact that only R&D success of both firms results in royalty
payments (see Table 1) and therefore the net payment 1: = 1, - 1, is the only
instrument to influence the effort decisons. However, it is not possible to influence
the R&D efforts of both firms appropriately by using the single parameter 1 14.
Choosing 1 can only serve to adjust (e,, e2) insofar that the differences in Pi und
ui are taken into consideration. This leads to the following licence fee:
v2n1- v1n2
(St)l* = n +n
withI-li=P;P;[(vI+v2)P;Pj-l]Iav,
2-0
(26)
1 2 aei

To sum up: It is possible to install a royalty scheme which induces the firms to
choose jointly optimal R&D levels at stage 2, except for (St). However, a more
thorough analysis will indicate situations where optimal R&D levels are not
feasible for (Be), (Bt) and (R) either.

3. Discussion of the results

3.1. Interpretation

The economic idea behind the results for (Bs) and (SS) is obvious: In the first
case each firm has an extra incentive for R&D effort, given by the licence fee

14
A similar problem arises in the literature about warranties: The warranty payment offers only
partial insurance, because it is not possible to induce the optimal quality level chosen by the seller and
the optimal level of care expended by the buyer [see Cooper and Ross (1985)I. In a more general sense
we have a team problem as in Holmstriim (1982): Only joint output (R&D success of both firms or
failure of at least one) is verifiable.
 K. Morasch/J. of Economic Behavior & Org. 28 (1995) 63-78 73

uj(l - Pi* ). Therefore it considers the profit uj of the cooperating firm, which
solely depends on Fi’s R&D success if firm Fj fails (the probability of this event
is 1 - Pi* ). In the second case, each firm considers the profit of the other firm if
this firm is successful.
In the other cases the expressions for optimal licence fees are too complex to
give a general economic interpretation. Two special cases seem to be interesting,
however:
1. In the case of (.St), the optimal licence fee rises with the expected profit of the
second firm. With identical R&D success functions Pi, the Iii will be identical
as well and therefore I * = (u2 - ui)/2. This royalty scheme gives each firm
the same R&D incentives and will result in identical R&D effort levels at
stage 2.
2. In the case of (Bt), the optimal royalty with identical R&D technology and
therefore P,* = Pg = P * can be written as follows:

(;+l)P’-1
(Bt) l; = (1 -P*)uj 2p* _ 1 (27)

With equal expected profits this expression coincides with the optimal royalties
in case of (Bs)

3.2. Ex post incentive compatibility

In the cases of (Bt) and (R), there may be optimal licence fees which make one
of the partners worse off if the know-how is transferred and royalty payments are
made. This situation arises for the licenser if the fees are negative and for the
licensee if the fees exceed his gross profit ui. At the contract date the firms do not
face a severe problem: Because the sum of expected profits is maximized by the
optimal royalty scheme, an unconditional payment to the potential loser will make
both firms better off. Consequently the cx ante participation constraints are met.
There will be problems expost, however: The firm which suffers the loss in case
of the know-how transfer has an incentive not to fulfill the contract. If R&D
success is not verifiable, such contracts cannot be enforced 15.Therefore the firms
have to consider ex post incentive compatibility as a constraint when designing
the cross-licensing agreement - to meet this ex post participation constraint
licence fees Ii must be an element of the interval IO, vj[.

” This is a problem of time (in-)consistency [see e.g. Wohltmann and Krijmer (198911: The “loser”
has ex post incentives to deviate from his ex altre optimal decision and, because R&D success is not
verifiable, a binding commitment is not possible. Note, however, that the contracts are renegotiation-
proof because they are Pareto-efficient [see Bolton (199o)I.
74 K. Morasch / J. of Economic Behavior & Org. 28 (I 995) 63-78

According to expressions (18) and (19) the optimal royalty scheme leads to fees
which are not incentive compatible ex post if 16:

(Bt) Pi* < --& A Pi* > --& (28)

I I ’ I

In the case of CR), R&D success is verifiable because a patent is awarded to the
winning firm. Therefore ex post incentive compatibility is only relevant if liquidity
constraints exist l7 . However, in the case of (Bt), the ex post participation
constraints have to be met. They tend to be binding if there are considerable
differences in R&D capabilities or expected gross profits ui. In such situations
only second best royalty schemes are feasible.
If firms do not specialize - cases CBS), (Bt) and (R) - and one firm’s R&D
capabilities are superior in a drastic way, the optimal royalty scheme may also
violate the ex post incentive compatibility constraint. Here, the sum of expected
profits will be maximized if only the superior firm undertakes R&D 18. For the
superior firm Pi Eq. (4) degenerates to (30) because e; = 0. Accordingly the Eqs.
(15)-(17) degenerate to (31).

WI + v,>=
VW (q + u2)Pi'- 1= 0 (30)
i?ei

(Bs,Bt,R)
acv,
+v2) = (Ui + 1J Pi'
- 1= 0 (31)
f3ei

To induce optimal R&D effort, the entire gross profit uj of the inferior firm
must be given to firm Pi via the royalty payment if firm Pi succeeds - in other
words li must equal uj. This, however, will give firm Fj incentives to conduct
R&D by itself, because it would not gain at all from a know-how transfer. To
ensure that the inferior firm chooses the optimal R&D effort ey = 0, it would be
necessary to choose a negative licence fee lj, which is not incentive compatible ex
post. If verifiability of R&D success is a problem, the first best royalty scheme is
not feasible.

l6 In the case of (Br), the expression for I, is not defined, if P,’ + Pj* = 1. However, generically,
this is not a problem.
r’ As discussed in the following paragraphs there might be a verifiability problem if - Zj > uj.
However, as long as it is optimal that both firms are active in R&D, Eq. (24) ensures that - Ii < u,, if
expected gross profits ui are positive.
l8 Note that this will never happen if the firms are specialized, because in this case it is always
necessary that both firms engage in research.
 K. Morasch/J. of Economic Behauior & Org. 28 (1995) 63-78 75

This might even be true in case of (Bs) and (R) if R&D success of firm 5 is
not verifiable by firm Fj as long as firm Fj does not use the R&D results (a
reasonable assumption if R&D effort is not observable). In this case the negative
licence fee will never be paid: If both firms are successful it is in the interest of
firm Fj to deny its own R&D success to avoid paying lljl - in this case li has no
influence on ex ante incentives. If only firm Fj is successful, it will realize profits
as long as vi > Iljl, which in turn may result in R&D incentives for Fj. With
vj < lljl the inferior firm would again deny R&D success. However, this contract
is not renegotiation proof because know-how transfer would result in a pareto-im-
provement. Therefore it is possible that the feasible royalty scheme will not induce
ei* = 0.

3.3. Second best royalties

To ensure the existence of a royalty scheme that induces the jointly optimal
R&D effort levels it must be ensured that (i) royalty payments can be based on
R&D results (R&D success has to be verifiable), and (ii) none of the firms has
drastically superior research capabilities (joint profits are maximized if both firms
do research work). If these two conditions are met and there are no synergy effects
of joint research, a cross-licensing agreement will be preferred to a joint venture.
If they are violated, the efficiency loss associated with a second best royalty
scheme must be compared with the differences in other transaction costs. In order
to determine the significance of the efficiency loss, we compared first best and
second best outcomes by means of a numerical simulation.
A general functional form which fulfills the conditions given in (1) was used:

Pi = 1 - ( &ei + l)-ai with ai,& > 0 (32)

In the cases of (Bt) and CR), parameter values for fyi and pi, which lead to
optimal royalty schemes that are not incentive compatible ex post, were deter-
mined. In order to model drastically superior research capabilities, we used
parameter values which induce an optimal R&D effort e; = 0. In the case of (St),
a drastic deviation from joint profit maximization was considered.
In the first three cases, the second best licence fees which maximize V, + V,
subject to the e.xpost participation constraint were determined. There are consid-
erable differences in the values for e, and Pi between the first best and the second
best. However, there are only minor effects on joint profits (less than 3% in the
worst case). In the case of (,St), on the other hand, the difference between first best
and second best joint profits may exceed 50%.
To sum up the simulation results: If firms do not specialize, moral hazard does
not call for joint ventures, because there are only minor differences between first
best and second best profit levels. If the firms specialize and R&D success is not
verifiable, a joint venture is necessary to handle the moral hazard problem.
76 K. Morasch /J. of Economic Behavior & Org. 28 (1995) 63-78

4. Conclusions

Based on transaction cost arguments, we have tried to explain why firms use
different governance modes - (ex ante) cross-licencing agreements and joint
ventures - when cooperating in R&D. It was assumed that there are no synergy
effects. Therefore joint ventures were solely used as a monitoring device to solve
the moral hazard problem. Moreover, it was argued that joint ventures cause
higher transaction costs because of more complex contracts and the necessity of
reorganization. Therefore cross-licensing agreements are the superior alternative if
they solve the moral hazard problem. Based on a model with uncertain R&D
success, we obtained the following result: Unless the firms specialize and the
unverifiability of R&D success makes it necessary to base licence fees on actual
know-how transfer, the moral hazard problem can be solved (at least approxi-
mately as the simulations suggest) by cross-licensing agreements. This is in line
with the results of the empirical research on contract forms stated in the introduc-
tion: The majority of R&D cooperation is based on cross-licensing agreements or
similar contract forms.
However, before applying our results to real world situations, one should have
in mind the basic assumptions of our analysis: (i) We modelled uncertainty in the
R&D process as a lottery with only two possible results: success or failure. Do the
results depend on this specification? (ii) We abstracted from synergy effects and
assumed that the firms are active in independent product markets. How will our
results change, if we relax these assumptions?
The first question is best addressed by relating our results to other work on
moral hazard in teams and optimal contract design for R&D cooperation where, in
contrast to our approach, specifications with a continuum of possible results are
used. In general the moral hazard problem can be solved as long as the firms are
risk neutral and there are at least as many verifiable ex post signals as unobserv-
able variables. This is, for example, the case in the dynamic patent race model of
Gandal and Scotchmer (1993) if there is only a moral hazard problem I9 because
of unobservable R&D investments: The identity of the discoverer and the date of
the discovery give two signals and there are no verifiability problems because a
patent is awarded to the winning firm. In this respect our results are confirmed in a
more general setting.
However, we also analyzed situations where R&D results are not patentable
and therefore verifiability problems may exist: (i) With specialization the unverifi-
ability of R&D success leads to a team problem as in Holmstriim (1982). In
generalizing our analysis it might be assumed that instead of success or failure
some continous variable like the “quality” of the research result is not verifiable.

I9 Gandal and Scotchmer (1993) also analyze the incentive problem with both moral hazard and
adverse selection.
 K. Morasch / J. of Economic Behavior & Org. 28 (1995) 63-78 77

For this case Holmstriim (1982) showed that, in general, there do not exist sharing
rules which are budget-balancing and yield the efficient effort decisions as a Nash
equilibrium. However, Radner (1991) argued that their may exist sharing rules
which induce efficient investments if the agents are risk neutral and sufficiently
different - an example with “complementary teams” is given by Vislie (1994).
Therefore, in contrast to our analysis, even with specialization and unverifiability
problems there may be situations where it is possible to solve the moral hazard
problem. (ii) With parallel research the unverifiability of R&D success makes it
necessary to base payments on actual know-how transfer. Because actual know-how
transfer is an ex post decision variable of the firms, only licence fees are feasible
which are incentive compatible ex post. If we use an explicitly dynamic model as
in Gandal and Scotchmer (19931, the basic problem would remain unchanged: If
one firm succesfully innovates, the other firm could either “buy” the innovation
and pay the contracted licence fee or it could continue its own research. Therefore
ex post incentive compatibility restricts feasible licence fees in the following way:
The payments must be positive (otherwise the successful innovator would not
transfer the innovation) and they must be low enough to ensure that the returns for
the licensee exceed the expected value of continuing its own research.
Concerning the second question, i.e. relaxing the assumptions about synergy
effects and product market competition, the following answers are obtained: (i> If
synergy effects of joint research exist, the higher transaction costs of joint ventures
have to be weighed against these benefits. When synergy effects are substantial, a
joint venture may be the superior contract form. (ii) If product market competition
between cooperating firms is introduced, there will be a second force which
influences the magnitude of the licence fees. Without competitive spillovers
cross-licensing agreement will use (positive) licence fees in order to solve the
moral hazard problem - otherwise the firms would not undertake enough R&D.
However, if the firms compete with each other in the product market, the R&D
effort levels in equilibrium without cooperation may exceed the jointly optimal
levels because of strategic overinvestment incentives. Katz (1986) shows that it
may be rational to sign royalty-free (ex ante) cross-licensing agreements in order
to reduce overinvestment in R&D. This may explain the empirical observation
that, in contrast to our argument, cross-licensing agreements often entail zero
licence-fees.

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