Extending Sutton’s “Bounds”: A Model of Endogenous Market Structure, Innovation, and Licensing

License agreements constitute between 20-33% of all strategic alliances in sectors commonly identified as likely candidates for an endogenous fixed cost (EFC) model; namely biotechnology and chemicals among others. We develop a model of endogenous market structure and fixed (sunk) cost R&D investment based on Sutton (1998; 2007) and include the ability of firms to license their technology to (potential) competitors. In our model we allow firms with asymmetric R&D costs to offer multiple products differentiated vertically by quality and horizontally by attributes. We also permit firms to pursue license and crosslicense agreements as an alternate form of market consolidation which is potentially less costly compared to firm integration via mergers or acquisitions. Thus, our analysis bridges two branches of the industrial organization literature and incorporates strategic alliances into an examination of the relationship between market structure and the intensity of R&D investment. Our results indicate that incorporating the ability of firms to license their technology increases the lower bound to market concentration in R&D-intensive industries relative to the levels that Sutton’s capabilities model would predict. In contrast with Sutton’s model which predicts a lower bound to R&D intensity that is equivalent to the lower bound to concentration, we find a strictly positive increase in the bounds to R&D intensity relative to concentration when firms are able to license their technology to rivals.