Suppose there is an initial innovator developing basic research and a follow-on innovator

developing an application. The basic research has no value to consumers (end-users) but costs

$250,000 to develop. The follow-on innovation has value of $400,000 per year, with of the

value going to consumers, to profits, and to deadweight loss. It costs $250,000 to develop.

The effective IP-protected lifespan of the innovation is 10 years. Suppose that an ex ante license

awards the initial innovator half of the profits from the follow-on innovator's application. The

follow-on innovator keeps the remaining half.

a. What are the initial innovator's profits under this licensing scheme? The follow-on

innovator's?

b. Draw the decision tree where first, the initial innovator decides whether or not to offer

an ex ante license. In each case, the follow-on innovator decides whether or not to

innovate. If no ex ante license was offered and the follow-on innovator innovated, the

initial innovator can decide whether or not to offer an ex post license, where the followon innovator gets share s between 0 and 1 and the initial innovator gets the remaining

share (1-s).

c. For what values of s with the outcome be an ex ante license (HINT: Find the values of s

such that the follow-on innovator will not innovate without first receiving an ex ante

license)?