Patent litigation and cross licensing with cumulative innovation

We investigate the firms' investment decisions in the presence of litigation over infringement and cross licensing as a way to settle. The model endogenously determines not only the timing of investments but also their capacities, the degree of overlap between the initial and the subsequent innovations, and the way the competitors resolve the dispute. It shows that the firms' R&D competition in the burgeoning market is more likely to entail a lawsuit and distinctly differentiated products, while they easily agree on cross licensing to utilize each other's works in the slow-growing market, leaving little difference between the products. From the perspective of public policy, it is clarified that the policy on patent scope cannot yield the first-best result in terms of the speed of innovation, and the welfare analysis shows that social welfare is higher when the conflict is settled via cross licensing. However, the weak protection on patent rights, which is shown to encourage cross licensing, does not always guarantee the highest level of social welfare since it weakens the leader's bargaining power in the negotiation, leading to fewer advanced products with higher prices.