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\begin{document}
\bigskip
\begin{center}
\begin{tabular}{c}
ECONOMIC ANALYSIS GROUP \\
DISCUSSION PAPER%
\end{tabular}
\bigskip \bigskip
\begin{tabular}{c}
Optimal Sharing Strategies in Dynamic Games of \\
Research and Development \\
by \\
Nisvan Erkal* and Deborah Minehart** \\
EAG 08-6 \ \ \ \ \ \ \ \ \ \ \ \ \ June 2008%
\end{tabular}
\end{center}
\bigskip \bigskip
EAG Discussion Papers are the primary vehicle used to disseminate research
from economists in the Economic Analysis Group (EAG) of the Antitrust
Division. These papers are intended to inform interested individuals and
institutions of EAG's research program and to stimulate comment and
criticism on economic issues related to antitrust policy and regulation. The
analysis and conclusions expressed herein are solely those of the authors
and do not represent the views of the United States Department of Justice.
Information on the EAG research program and discussion paper series may be
obtained from Russell Pittman, Director of Economic Research, Economic
Analysis Group, Antitrust Division, U.S. Department of Justice, BICN 10-000,
Washington, DC 20530, or by e-mail at russell.pittman@usdoj.gov. Comments on
specific papers may be addressed directly to the authors at the same mailing
address or at their e-mail address.
Recent EAG Discussion Paper titles are listed at the end of this paper. To
obtain a complete list of titles or to request single copies of individual
papers, please write to Janet Ficco at the above mailing address or at
janet.ficco@usdoj.gov or call (202) 307-3779. Beginning with papers issued
in 1999, copies of individual papers are also available from the Social
Science Research Network at www.ssrn.com.
We are grateful to Sue Majewski, John Rust, Suzanne Scotchmer, and
especially John Conlon and Ethan Ligon for their comments. We also would
like to thank conference participants at AEA Annual Meetings (2007), NASM
(2007), ESAM\ (2006), Midwest Economic\ Theory Meetings (2006), SAET (2005),
IIOC (2005), and seminar participants at Case Western Reserve University,
U.S. Department of Justice, University of Adelaide, University of Arkansas,
University of California-Berkeley, University of Colorado-Boulder,
University of Concordia, University of Melbourne, and University of
Missouri-Columbia for their comments. In the initial stages of this project,
we have benefited from conversations with Eser Kandogan, Ben Shneiderman,
and members of the Research Division of IBM. We thank Christian Roessler for
his help with the numerical analysis. Nisvan Erkal thanks the Faculty of
Economics and Commerce, University of Melbourne for its financial support.
*Department of Economics, University of Melbourne, Victoria 3010, Australia.%
\newline
n.erkal@unimelb.edu.au. \newline
**United States Department of Justice, Washington, D.C. 20530, USA.
\newpage
\begin{description}
\item[Abstract: ] This paper builds a theoretical foundation for the
dynamics of knowledge sharing in private industry. In practice, research and
development projects can take years or even decades to complete. We model an
uncertain research process, where research projects consist of multiple
sequential steps. We ask how the incentives to license intermediate steps to
rivals change over time as the research project approaches maturity and the
uncertainty that the firms face decreases. Such a dynamic approach allows us
to analyze the interaction between how close the firms are to product market
competition and how intense that competition is. If product market
competition is relatively moderate, the lagging firm is expected never to
drop out and the incentives to share intermediate research outcomes
decreases monotonically with progress. However, if product market
competition is relatively intense, the incentives to share may increase with
progress. These results illustrate under what circumstances it is necessary
to have policies aimed at encouraging cooperation in R\&D and when such
policies should be directed towards early vs. later stage research.
\end{description}
\bigskip
\begin{description}
\item[JEL\ Codes:] L24,O30,D81
\item[Keywords:] Multi-stage R\&D; innovation; knowledge sharing; licensing;
dynamic games.
\end{description}
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\section{Introduction\label{introduction}}
This paper builds a theoretical foundation for the dynamics of knowledge
sharing in private industry. As evidenced by the substantial evidence on
licensing, research alliances and joint ventures, knowledge sharing
arrangements are a central way in which firms acquire technological
knowledge. From a social welfare perspective, sharing of research outcomes
is desirable because it results in less duplication. Since the 1980s,
governments in the US and Europe have actively promoted joint R\&D projects
through subsidies, tolerant antitrust treatment, and government-industry
partnerships.\footnote{%
For example, in the US, the National Cooperative Research and Production Act
(NCRPA) of 1993 provides that research and production joint ventures be
subject to a `rule of reason' analysis instead of a per se prohibition in
antitrust litigation. In the EU, the Commission Regulation (EC) No 2659/2000
(the EU\ Regulation) provides for a block exemption from antitrust laws for
RJVs, provided that they satisfy certain market share restrictions and allow
all joint venture participants to access the outcomes of the research.} At
the same time, economics research has studied the private and social
incentives to have knowledge sharing arrangements, focusing on issues of
appropriability and spillovers. However, none of these studies has focused
on the basic dynamics of private sharing incentives. Research projects in
industries such as biotechnology and computers can take years or even
decades to complete. Over such long time horizons, there is considerable
scope for the sharing strategies of firms to change. Firms may decide to
share some intermediate steps, but not all of their research outcomes. For
example, Oxley and Sampson (2004) show that direct competitors choose to
limit the scope of their alliances to activities which can be considered to
be further away from the product market.\footnote{%
Oxley and Sampson (2004) base their study on a sample of R\&D alliances
involving companies in the electronics and telecommunications equipment
industries. They define the scope of alliances in terms of R\&D,
manufacturing and marketing activities, and show that competitors are averse
to adding joint manufacturing and marketing activities to their R\&D
collaborations. In a study of biotechnology alliances, Lerner and Merges
(1998) find that while in a few cases the alliances covered technologies
well along the way to regulatory approval, in most cases they were arranged
at the earliest stages of research (prior to animal studies, clinical trials
and regulatory approval).} Focusing on the dynamics of research, we ask how
the incentives to license research outcomes to rivals change over time as a
research project approaches maturity.
A question central to the policy debate as well as the study of knowledge
sharing arrangements is the impact of competition on cooperation. This is
because in many cases, the most suitable research partner for a firm may be
one of its competitors. However, such sharing poses especially difficult
challenges because they may result in a reduction in the commercial value of
the firms' R\&D efforts. Hence, it is important to determine how close
profit-driven firms come to maximizing welfare. A dynamic perspective allows
us to analyze the impact of competition on cooperation in two different
ways. We can analyze the impact of both how close the firms are to product
market competition and how intense that competition is. Our results reveal
an interesting interaction between these two factors.
From a dynamic perspective, the process of research is generally
characterized by a high level of uncertainty in the beginning. For example,
at the outset of a research on a new medical drug, the expected success rate
may be as low as 2\% and the expected time to market may be more than a
decade.\footnote{%
See Northrup (2005).} In such environments, progress in research can be
described as a decrease in the level of uncertainty that researchers face.
By the time a new drug is a few years from market, there is far less
uncertainty about its chance of success and value than at the outset. One of
the novel aspects of this project is to focus on the role uncertainty plays
in the decisions to share knowledge and to analyze how firms' incentives to
share research outcomes change during a research process as the level of
uncertainty they face decreases. We show that the impact of uncertainty on
firms' sharing incentives depends on the intensity of product market
competition.
We assume that research projects consist of several sequential steps.
Researchers cannot proceed to the next step before successfully completing
the prior step. Moreover, they cannot earn any profits before completing all
steps of the project. An important feature of the model is that we assume
the different steps of research are symmetric in all respects except in
regards to how far away they are from the end of the project. That is, the
options and technology available to the firms are the same in all steps of
the research process. We deliberately assume that there are no spillovers in
research.\footnote{%
In the literature on research joint ventures, knowledge spillovers are
stated as one of the most important reasons for rival firms to agree to
share knowledge.} It has been stressed in the literature that firms may have
higher spillover rates and bigger appropriability problems in earlier stages
of research than in later stages of research.\footnote{%
See, for example, Katz (1986), Katz and Ordover (1990), and Vonortas (1994).}
Although the rate of spillovers may shape the dynamics of sharing, we show
that this is not the only factor that matters. Assuming that there are no
spillovers between the research efforts of different firms allows us to
focus on the role uncertainty plays in knowledge sharing.
We assume that firms are informed about the progress of their rivals and
make joint sharing decisions after each success. In a dynamic R\&D process,
firms' incentives to share change as their positions in the race change for
two reasons. First, the probability that the firms will survive to be rivals
in the product market changes with progress. Second, the ability of the
leading firm to earn monopoly profits depends on the progress the firms make
during the research process. Because sharing decreases the lead of one firm,
it reduces the expected profits that the leader derives from finishing the
race first and being a monopolist for some period of time. This cost may be
even greater if, but for the sharing, the lagging firm would drop out of the
race.
The results reveal that the nature of the sharing dynamics depends
critically on whether product market competition allows for the co-existence
of competing firms. If duopoly profits are relatively high, firms that are
lagging in the research phase would pursue duopoly profits rather than
exiting. In this case, the incentives to share intermediate research
outcomes decreases monotonically with progress. However, if duopoly profits
are relatively low, a lagging firm exits the race once it falls behind
(e.g., as in a winner-take-all-market). In this case, the incentives to
share intermediate research outcomes may be weakest early on.
These results have important implications for policy-making in innovation
environments. They show that the design of optimal knowledge sharing policy
should be sensitive to the dynamic sharing patterns which would emerge in
the absence of such policy. What is needed to encourage sharing in early
stages of an innovation may be different from what is needed to encourage
sharing in later stages. Moreover, whether policies should be optimally
directed towards early stage or later stage research may depend on the
particular industry because of differences in the intensity of competition.
As mentioned above, the impact of competition on cooperation in R\&D has
also been the focus of many papers in the economics literature. These papers
have mainly studied firms' incentives to share research outcomes at one
point in time, either before the start of research, as in the case of
research joint ventures, or after the development of a technology, as in the
case of licensing.\footnote{%
See, for example, Kamien (1992) on licensing, and Reinganum (1981), Katz
(1986), D'Aspremont and Jacquemin (1988) and Kamien, Muller and Zang (1992)
on research joint ventures. Patenting and informal sharing between employees
of firms are two other methods through which knowledge may be disseminated
between firms. See, for example, Scotchmer and Green (1990) on early
innovators' incentives to patent and Severinov (2001) on informal sharing
between employees.} A general result in these papers is that the intensity
of product market competition decreases the incentives to cooperate.%
\footnote{%
For example, Choi (1993)\ shows that competing firms will cooperate if the
level of spillovers are sufficiently high. Wang (2002) shows that licensing
between competitors will take place if they produce sufficiently
differentiated products. Empirical evidence suggests that firms do take
measures to avoid opportunistic behavior when they are collaborating with
their competitors. For example, Majewski (2004) shows that direct
competitors are more likely to outsource their collaborative R\&D. Oxley and
Sampson (2004) show that direct competitors choose to limit the scope of
alliance activities.} We contribute to this literature by focusing on the
dynamics of sharing.
In addition to contributing to the literature on knowledge sharing, this
paper is also related to the literature on how firms' optimal strategies
change over time in a dynamic model of R\&D. In this literature, Grossman
and Shapiro (1986 and 1987) analyze how firms vary their research efforts
over the course of a research project. In an infinite-period race, Cabral
(2003) allows firms to choose between two research paths with different
levels of riskiness. He shows that the leader chooses a safe technology and
the laggard chooses a risky one. Judd (2003) shows that there is excessive
risk-taking by innovators.
The paper proceeds as follows. In the next section, we describe the set-up
and explain, as a benchmark, what happens if the firms are allowed to
collude in the product market. In section \ref{sharing-dynamics}, we define
the monotonicity property which we use in our characterization of the
sharing dynamics under rivalry. In section \ref{ex-post-sharing}, we analyze
the effect of competition on the dynamic sharing incentives of firms in a
model with ex-post sharing contracts and two research steps. The case of $N$
research steps is considered in section \ref{N-step}. In sections \ref%
{asymmetric-firms} and \ref{patent-policy}, we discuss extensions of our
basic model with asymmetric firms and patenting of research outcomes,
respectively. We conclude in section \ref{conclusion}.
\section{Model \label{model}}
Since we are interested in the effect of competition on firms' incentives to
share, we consider an environment with two firms, $i=1,2$, which invest in a
research project. On completion of the project, a firm can produce output in
a product market. We will consider Markov Perfect Equilibria (MPE), where
each firm maximizes its discounted expected continuation payoff given the
Markov strategy of the other firm. Before describing the payoffs and the
MPE, we first give an overview of the research and production phases.
\subsection{Research Environment \label{research-environment}}
To capture the idea of progress, we assume that a research project has $N$
distinct steps of equal difficulty. Hence, we assume that the firms divide
the research project into different steps and that each firm defines the
steps in the same way. A firm cannot start to work on the next step before
completing the prior step, and all steps of the project need to be completed
successfully before a firm can produce output.
There is no difference between the steps in terms of the technology or the
options available to the firms. This is because we seek to derive endogenous
differences in the research phases that result from the dynamics in the
decisions made by the firms. A basic intuition is that as firms approach the
end of the research process, their decisions might increasingly reflect the
impending rivalry.
We assume that each firm operates an independent research facility. We model
research activity using a Poisson discovery process. Time is continuous, and
the firms share a common discount rate $r$. To conduct research, a firm must
incur a flow cost $c$ per unit of time.\footnote{%
We do not allow the firms to choose continuous levels of research effort.
This assumption can be motivated by presuming a fixed amount of effort that
each firm can exert, which is determined by the capacity of its R\&D
division. As an example, Khanna and Iansiti (1997) explain that given the
highly specialized nature of the R\&D involved in designing state-of-the-art
mainframe computers, firms in this industry find it very expensive to
increase the number of researchers available to them.} Investment provides a
stochastic time of success that is exponentially distributed with hazard
rate $\alpha $. This implies that at each instant of time, the probability
that the firm completes a step is $\alpha $. After completing a step, a firm
can immediately begin research on the next step. For a firm which has not
yet completed the project, a decision not to invest the flow cost $c$ is
assumed to be irreversible and equivalent to dropping out of the game.
When one firm (the leading firm) successfully completes a stage of research
before the other firm (the lagging firm) does, we assume that the leading
firm can share this knowledge with the lagging firm and thereby save the
lagging firm from having to continue to invest to complete the stage. From
the point of view of social efficiency, such sharing will always be
efficient because it prevents resources from being spent to duplicate
research results. There are a variety of ways to model the sharing process.
We consider ex post sharing or licensing, where the leading firm shares its
result with the lagging firm in exchange for a licensing fee. Sharing can
occur instantaneously whenever one firm has completed more stages of
research than the other. The leader makes a take-it-or-leave-it offer to the
lagging firm. If the lagging firm accepts the offer, he pays the licensing
fee to the leader who then shares one step of research. After the sharing
takes place, each firm that is not yet done with the project decides whether
or not to invest.
Regarding the information structure, we assume that the lagging firm cannot
observe the technical content of the rival's research without explicit
sharing.\footnote{%
Alternatively, we could assume that research results can be copied, but
successful firms win immediate patents. A leading firm could then prevent a
lagging firm from copying its research by enforcing its patent. If the
patent does not prevent the rival from developing a non-infringing
technology at the same flow cost $c$ and with the same hazard rate, then the
formal set up would be equivalent to ours. We consider the case when
patenting changes the research cost of the lagging firm in section \ref%
{patent-policy}.} In this sense, there are no technological spillovers.
Everything else in the game is common knowledge. In particular, firms
observe whether their rival is conducting research as well as whether the
rival has a success. Third parties such as courts also observe this
information and can enforce the licensing contracts.
\subsection{Product Market Competition \label{product-mkt}}
After a firm completes all stages of the research process, it can
participate in the product market. The firms produce goods that may be
either homogeneous or differentiated, and that they compete as duopolists in
the product market.\footnote{%
We assume that the firms conduct the research to solve the same technical
problem. However, unmodelled differences in production technologies can
still lead them to produce differentiated products.} We represent the
product market competition in the following reduced form way.
If both firms have completed the research project, they compete as
duopolists and each earns a flow profit of $\pi ^{D}\geq 0$ forever. If only
one firm has completed the research project, the firm earns a monopoly flow
profit of $\pi ^{M}>0$ as long as the other firm does not produce output.
Here, $\pi ^{M}>\pi ^{D}$. As a benchmark, we will consider the case that
the firms make production decisions to maximize their joint profits in the
product market. This results in a joint flow profit of $\pi ^{J}$ where $\pi
^{J}\geq 2\pi ^{D}$ and $\pi ^{J}\geq \pi ^{M}$. We use the notation $%
\widetilde{\pi }^{D}=\frac{\pi ^{D}}{r}$, $\widetilde{\pi }^{M}=\frac{\pi
^{M}}{r}$, and $\widetilde{\pi }^{J}=\frac{\pi ^{J}}{r}$.
These payoffs are sufficiently flexible to capture various models of product
competition. For example, if the firms produce homogeneous products and
compete as Bertrand or Cournot competitors, then $\pi ^{J}=\pi ^{M}>2\pi
^{D} $. If the firms produce differentiated products, then $\pi ^{J}>\pi
^{M} $ and the relationship between $\pi ^{M}$ and $2\pi ^{D}$ will depend
on the degree of product differentiation that exists between the products.
For low levels of product differentiation, $\pi ^{M}>2\pi ^{D}$; for high
levels of product differentiation, $\pi ^{M}\leq 2\pi ^{D}$.\footnote{%
The magnitudes of $\pi ^{D}$, $\pi ^{J}$ and $\pi ^{M}$ do not depend on the
decisions taken during the research phase.}
As an example, consider a demand function of the type $q_{i}=\left( a\left(
1-\gamma \right) -p_{i}+\gamma p_{j}\right) /\left( 1-\gamma ^{2}\right) $,
where $0<\gamma <1$ so that the products are substitutes.\footnote{%
Singh and Vives (1984) show how these demand functions derive from
particular consumer preferences. The Hotelling model provides another
example of a differentiated duopoly.} The goods are less differentiated the
higher is $\gamma $. It is possible to show that $\pi ^{M}\leq 2\pi ^{D}$ if
and only if $\gamma $ is sufficiently small.
To denote the space for technology and profit parameters, we use $\Omega =\{%
\mathbf{\omega =}(\alpha ,r,c,\pi ^{M},\pi ^{D})$ such that $0<\alpha
<1,00,\pi ^{M}>\pi ^{D}\geq 0\}$.
\subsection{Research Histories, Equilibrium, and Payoffs \label%
{histories-equilibrium-payoffs}}
\textbf{Research histories }To represent the progress made by the firms, we
define a set of research histories.\footnote{%
A research history is not a full history of the game, but rather a state
variable that captures the payoff relevant history of the game.} We use the
notation $\mathbf{h}=(h_{1},h_{2})$, where $h_{i}$ stands for the number of
steps that firm $i$ has completed. When firm $i$ completes a research step, $%
h_{i}$ increases by one. From a dynamic perspective, what matters is whether
one research history precedes another. The research histories are partially
ordered so that $\mathbf{h}$ is \textit{earlier} than $\mathbf{h}^{\prime }$
if and only if $h_{i}\leq h_{i}^{\prime }$ for $i=1,2$, with strict
inequality for at least one firm. In the following analysis, we refer to
research histories where $h_{1}=h_{2}$ as symmetric histories and to those
where $h_{1}\neq h_{2}$ as asymmetric histories.
If a firm has dropped out of the game, we use $X$ to denote this in the
research history. The set of research histories is%
\begin{equation*}
H=\{((h_{1},h_{2}),(h_{1},X),(X,h_{2})\text{ for }h_{i}=1,...N\text{ and }%
i=1,2\}
\end{equation*}
\textbf{Markov strategies and equilibrium }We will restrict attention to
strategies that depend only on the research histories in $H$. At each
history, the set of available actions for firm $i$ is as follows. At
symmetric histories $(h,h)$ with $hh_{2} \\
V_{1}\left( h_{1},h_{2}\right) &=&V_{1}\left( h_{1}+1,h_{2}\right) -F\left(
h_{1},h_{2}\right) \text{ if }h_{1}0$ is a fixed gap between the leading firm and the lagging firm. The size
of the gap can be as small as $1$ or as large as $N-1$.
Because the sharing decision is made jointly, the firms share whenever it
raises their joint profits. At $(h+g,h),$ sharing changes the history to $%
(h+g,h+1)$. The following equilibrium sharing condition is central to our
analysis:%
\begin{equation}
V_{J}\left( h+g,h+1\right) >V_{J}\left( h+g,h;NS\right) \text{,}
\label{sharing-condition}
\end{equation}%
where $V_{J}=V_{1}+V_{2}$ is the joint value function.
A sharing pattern is an ordered sequence of sharing decisions covering all
histories with the same gap. For example, when $N=2$, the sharing pattern
for the case when the leader is one step ahead of the lagging firm specifies
sharing decisions at $(1,0)$ and $(2,1)$. For $N=2,$ there is only one
sharing pattern, where $g=1$. For larger $N,$ there is a sharing pattern for
each gap $g=1,...,N-1$.\ The next definition states a formal monotonicity
property for the general $N$-step model. We define the property for
histories such that firm $1$ is the leader. Because the equilibria in our
game are symmetric, when the property holds, it also holds for histories
such that firm $2$ is the leader.
\begin{definition}
\label{definition-monotonicity}An equilibrium satisfies the monotonicity
property if whenever the firms share at the history $(h+g,h)$, then they
also share at the earlier history $(h^{\prime }+g,h^{\prime })$ where $%
h^{\prime }V_{J}(2,1;NS)$. If the firms
share, they compete as duopolists in the product market and earn joint flow
profits of $2\pi ^{D}$. Their continuation profits are $V_{J}(2,2)=2%
\widetilde{\pi }^{D}$. If the firms do not share, the leading firm earns a
flow profit of $\pi ^{M}$ and the lagging firm invests $c$ until the lagging
firm finishes. Their joint continuation profits are $V_{J}(2,1;NS)=%
\int_{0}^{\infty }e^{-\left( \alpha +r\right) t}\left( \pi ^{M}-c+\alpha
V_{J}(2,2)\right) dt$. The sharing condition simplifies to
\begin{equation}
2\pi ^{D}-(\pi ^{M}-c)>0. \label{Sharing at (2,1)}
\end{equation}
At the earlier history $(1,0)$, the sharing condition is $%
V_{J}(1,1)>V_{J}(1,0;NS)$. The joint payoffs at $(1,1)$ and $(1,0;NS)$
depend on future sharing decisions at $(2,1)$ and $(2,0)$. Hence, we
consider these decisions first.
First, consider the case when condition (\ref{Sharing at (2,1)}) fails,%
\footnote{%
By failing, we mean that the inequality in condition (\ref{Sharing at (2,1)}%
) is reversed. The special case that the condition holds with equality is
considered in the appendix and is discussed further below.} so the firms do
not share at $(2,1)$. As shown in the appendix, the sharing condition at $%
(2,0)$ is the same as the sharing condition at $(2,1)$. Thus, the firms do
not share at $(2,0)$ either. To understand why, note that sharing at $(2,0)$
changes the history to $(2,1)$ and allows the lagging firm to reach the
product market sooner. When this happens, the flow profits $(\pi ^{M}-c)$
are replaced by the flow profits $2\pi ^{D}$ for a net loss of $2\pi
^{D}-(\pi ^{M}-c)$. To avoid this loss, the firms do not share at $(2,0)$.
Now, consider the sharing condition at $(1,0)$. At $(1,0),$ there is a new
benefit of sharing that did not exist at $(2,1)$. The lagging firm now has a
chance of finishing first. If the firms knew that firm $2$ would finish
first, they would want to share at $(1,0)$ so as to realize monopoly profits
sooner. In contrast, if the firms knew that firm $1$ would finish first,
then they would not want to share at $(1,0)$ because this shortens the
duration of monopoly profits. We can re-write the sharing condition (\ref%
{RegionA-sharing-1-0-case2}) in the appendix in the following way: \ \
\begin{equation}
\beta (\pi ^{M}+c)+(1-\beta )(2\pi ^{D}-(\pi ^{M}-c))>0\text{,}
\label{Sharing at (1,0) if NS at (2,1)}
\end{equation}%
where $\beta =\frac{(\alpha +r)^{2}}{(2\alpha +r)^{2}}$. The second term in (%
\ref{Sharing at (1,0) if NS at (2,1)}) is the net loss in joint flow profits
when the leading firm finishes first. This is the same as condition (\ref%
{Sharing at (2,1)}) and is negative. The first term in (\ref{Sharing at
(1,0) if NS at (2,1)}) is the increase in joint flow profits when the
lagging firm finishes first. Here, the firms jointly benefit from replacing
the lagging firm's R\&D costs $-c$ with monopoly profits $\pi ^{M}$. The net
benefit, $\pi ^{M}+c$, is positive. The $\beta $ and $(1-\beta )$ can be
interpreted as weighted probabilities, where flow profits that arrive
earlier in time have greater weight. There is a weighted probability $\beta $
that the lagging firm finishes first and a weighted probability $(1-\beta )$
that the leading firm finishes first. Since $\beta >0$, condition (\ref%
{Sharing at (1,0) if NS at (2,1)}) is easier to satisfy than (\ref{Sharing
at (2,1)}) so that the monotonicity result holds. At $\left( 2,1\right) $, $%
\beta =0$ because the leading firm was already done.
When condition (\ref{Sharing at (1,0) if NS at (2,1)}) holds, there is a
unique MPE with the sharing pattern (S,NS). When it fails, there is a unique
MPE with the sharing pattern (NS,NS). When the condition holds with
equality, there are two MPEs, one for each sharing pattern.
Next, consider the case when condition (\ref{Sharing at (2,1)}) holds, so
the firms share at $(2,1)$. As shown in the appendix, the sharing condition
at $(2,0)$ is again the same as the sharing condition at $(2,1)$ and is
given by condition (\ref{Sharing at (2,1)}). Thus, the firms share at $(2,0)$
also.
As shown in the appendix, the sharing condition at $(1,0)$ simplifies to
\begin{equation}
\pi ^{D}+c>0\text{,} \label{Sharing at (1,0) if S at (2,1)}
\end{equation}%
which holds trivially and implies that the equilibrium sharing pattern is
(S,S). Since the firms share at both $(2,1)$ and $(2,0),$ neither firm can
ever earn monopoly profits and, thus, there is no cost to sharing at $(1,0)$%
. Sharing merely reduces the expected time to market and expected R\&D\
costs by enabling the lagging firm to finish sooner. The sharing condition
captures the change in joint flow profits when this happens. When the
lagging firm reaches the history $(1,2)$, the firms share so that both firms
enter the product market. As shown in (\ref{Sharing at (1,0) if S at (2,1)}%
), the joint flow profits increase from $-2c$ to $2\pi ^{D}$ for a net
benefit of $2(\pi ^{D}+c)>0$. Sharing at $(1,0)$ creates this benefit by
enabling the firms to reach the history $(1,2)$ sooner and with a higher
probability. Clearly, condition (\ref{Sharing at (1,0) if S at (2,1)}) is
easier to satisfy than condition (\ref{Sharing at (2,1)}) in so far as it
holds for more parameter values.
In summary, there are two explanations for why sharing patterns are
monotonic. The first explanation is that if the firms do not share at $(2,1)$%
, sharing at $\left( 1,0\right) $ may still be beneficial because it enables
the lagging firm to finish first and earn monopoly profits sooner. The
second explanation is that future sharing at $(2,1)$ and $(2,0)$ eliminates
the ability of either firm to earn monopoly profits. This eliminates the
cost of sharing earlier in the game and explains why (\ref{Sharing at (1,0)
if S at (2,1)}) holds trivially. It is interesting to note that the dynamics
described above continue to hold when research costs $c$ are zero. In
particular, savings of duplicated R\&D costs are not the only reason the
firms find it optimal to share. Firms are also motivated to share so that
they can reduce the time needed for one or both to reach the product market.
\subsubsection{Comparative Statics}
We next consider how the extent of sharing is affected by changes in
parameters to better understand the dynamic motivations for sharing. From
Proposition \ref{prop-monotonicity}, we can describe a monotonic sharing
pattern by the number of histories in which the firms choose to share. For
example, (NS,NS) implies that there are no histories with sharing while
(S,NS) implies that there is one and (S,S) implies that there are two
histories with sharing.
\begin{corollary}
\label{comparative-statics} Consider any $\mathbf{\omega =(}\alpha ,r,c,\pi
^{M},\pi ^{D}\mathbf{)}$ and $\mathbf{\omega }^{\prime }\mathbf{=(}\alpha
^{\prime },r^{\prime },c^{\prime },\pi ^{M^{\prime }},\pi ^{D^{\prime }}%
\mathbf{)}$ in Region A such that $\alpha \leq \alpha ^{\prime },r\geq
r^{\prime },c\geq c^{\prime },\pi ^{M}\leq \pi ^{M^{\prime }}$ and $\pi
^{D}\geq \pi ^{D^{\prime }}$. Select a MPE at $\mathbf{\omega }$ and $%
\mathbf{\omega }^{\prime }$ and consider the associated sharing patterns.
There are weakly more histories with sharing at $\mathbf{\omega }$ than at $%
\mathbf{\omega }^{\prime }$.
\end{corollary}
The Corollary is proved by an examination of the sharing conditions given in
(\ref{Sharing at (2,1)}), (\ref{Sharing at (1,0) if NS at (2,1)}), and (\ref%
{Sharing at (1,0) if S at (2,1)}). Intuitively, it is clear that an increase
in duopoly profits, $\pi ^{D}$, or in the research cost, $c$, increases the
attractiveness of sharing. Both enter with a positive sign in each sharing
condition. The effects of the other parameters are less obvious.
First, consider the comparative statics result for monopoly profits, $\pi
^{M}$. Condition (\ref{Sharing at (2,1)}) implies that an increase in $\pi
^{M}$ decreases the incentive to share at $(2,1)$. This is because sharing
erodes the monopoly profits of the leading firm. At the earlier history $%
(1,0)$, however, the role of $\pi ^{M}$ is more complex. As seen in (\ref%
{Sharing at (1,0) if S at (2,1)}), if the firms share at $\left( 2,1\right) $%
, then an increase in $\pi ^{M}$ has no effect on the sharing decision at $%
(1,0)$. This is because the firms never earn monopoly profits due to future
sharing. If the firms do not share at $\left( 2,1\right) $, an increase in $%
\pi ^{M}$ can either increase or decrease the incentive to share at $(1,0)$.
As shown in (\ref{Sharing at (1,0) if NS at (2,1)}), if $\beta <\frac{1}{2}$%
, the sharing condition at $(1,0)$ gives more weight to the erosion of
monopoly profits for the leading firm, $(2\pi ^{D}-(\pi ^{M}-c))$. This term
is decreasing in $\pi ^{M}$. If $\beta >\frac{1}{2}$, the sharing condition
gives more weight to the benefit of sharing for the lagging firm, $\pi
^{M}+c $, which is increasing in $\pi ^{M}$. Corollary \ref%
{comparative-statics} states that an increase in $\pi ^{M}$ always results
in fewer histories with sharing. When $\beta <\frac{1}{2}$, this is clearly
true. When $\beta >\frac{1}{2}$, the result holds weakly because, even
though the underlying effect of an increase in $\pi ^{M}$ is to increase the
incentives to share, the firms share at $(1,0)$ regardless of $\pi ^{M}$. To
see this, note that the lowest value of $\pi ^{M}$ in our parameter space is
$\pi ^{M}=\pi ^{D}$. At this value of $\pi ^{M}$, if $\beta >\frac{1}{2}$,
condition (\ref{Sharing at (1,0) if NS at (2,1)}) holds. For larger $\pi
^{M} $, thus, the condition also holds.
Next, consider the comparative statics results for $r$ and $\alpha $. Of the
three sharing conditions above, the only one affected by $r$ and $\alpha $
is (\ref{Sharing at (1,0) if NS at (2,1)}). This is the condition for
sharing at $(1,0)$ if the firms do not share at $(2,1)$.\footnote{%
The sharing condition (\ref{Sharing at (2,1)}) at $(2,1)$ is not affected by
$\frac{r}{\alpha }$ because the cost and benefit of sharing are incurred at
the same time in the flow of profits. Similarly, in the sharing condition (%
\ref{Sharing at (1,0) if S at (2,1)}) at $(1,0)$, when the firms share at $%
(2,1)$, $\frac{r}{\alpha }$ does not affect the flow benefit of sharing
given by $2(\pi ^{D}+c)$.} The parameters $r$ and $\alpha $ enter (\ref%
{Sharing at (1,0) if NS at (2,1)}) through the parameter $\beta $ which is
increasing in $\frac{r}{\alpha }$. The ratio $\frac{r}{\alpha }$ can be
interpreted as a discount factor. The underlying interest rate $r$ is
adjusted by the effectiveness $\alpha $ of the research technology. As $%
\frac{r}{\alpha }$ increases, the firms become more impatient and so place
more weight on reducing the delay until at least one of them enters the
product market and less weight on extending the duration of monopoly
profits. This makes sharing more appealing. In fact, for $\beta >\frac{1}{2}$%
, sharing at $(1,0)$ is always optimal, even for arbitrarily large values of
$\pi ^{M}$.
Figure \ref{equilibrium outcomes} lists the sharing patterns for different
regions. The parameters $\alpha ,r,$ and $c$ are fixed, but $\pi ^{D}$ and $%
\pi ^{M}$ are allowed to vary. The right hand side of the diagram, where $%
\pi ^{D}\geq c\frac{r}{\alpha }(2+\frac{r}{\alpha })$, depicts the
equilibrium outcomes in Region A. Consider how the sharing pattern changes
as $\pi ^{M}$ increases for a given value of $\pi ^{D}$. The values of $r$
and $\alpha $ yield $\beta <\frac{1}{2}$ so that an increase in $\pi ^{M}$
increases the incentive to choose NS at all the histories. For small values
of $\pi ^{M}$, the sharing pattern is (S,S). As monopoly profits increase,
sharing breaks down at the history $(2,1)$ and the sharing pattern is
(S,NS). As monopoly profits increase further, sharing eventually breaks down
at the earlier history $(1,0)$ as well, so the sharing pattern is (NS,NS).
Hence, as $\pi ^{M}$ increases, sharing breaks down, but it breaks down at
later histories first.\FRAME{ftbpFU}{4.6011in}{3.8439in}{0pt}{\Qcb{%
Equilibrium Outcomes for\ $\protect\alpha =.5$, $r=.2$ and $c=.5$}}
%See text for a description of Figure 1
\subsubsection{Licensing Fees}
To finish, we briefly discuss individual payoffs and licensing fees. Since
sharing decisions are made jointly, they do not depend on this analysis.
However, it is still interesting to consider the dynamics of the licensing
fees. In light of the monotonicity we have observed in the sharing
incentives, a natural question that arises is whether the licensing fees
display a similar type of dynamics. We find that this is not necessarily the
case. Although the joint incentives to share decline over time, the
licensing fees paid by the lagging firm may increase or decrease over time
depending on the magnitude of $\frac{r}{\alpha }$.
Recall that whenever the firms share, the leading firm makes a
take-it-or-leave-it offer to the lagging firm. Since the leading firm has
all the bargaining power, it offers a licensing fee that leaves the lagging
firm just indifferent between accepting and rejecting. In section \ref%
{licensing-fees-calculation} of the appendix, we analyze an MPE\ in which
the firms share at all histories. We find that both firms have a higher
payoff at $(2,1)$ than at $(1,0)$. Essentially, this is because costs are
invested upfront while profits are earned later and are discounted. Hence,
as the game progresses, individual payoffs rise. For this reason, if $\frac{r%
}{\alpha }$ is sufficiently high, the licensing fees also increase over
time. This is in contrast with the sharing incentives which decrease over
time.
For sufficiently small values of $\frac{r}{\alpha }$, the dynamics of the
sharing incentives do, however, determine the dynamics of the licensing
fees. The benefit from sharing\textit{\ }to the lagging firm\ (as opposed to
the joint benefit) is higher at $(1,0)$ than at $(2,1)$ because at $(1,0)$,
sharing helps the lagging firm to finish first and earn a licensing fee at $%
(1,2)$. This effect dominates for sufficiently small values of $\frac{r}{%
\alpha }$ and $F(1,0)>F(2,1)$. This is because when $\frac{r}{\alpha }$ is
small, discounting does not reduce the payoffs early in the game by much.
Since discounting plays a smaller role than the sharing dynamics in the
determination of the licensing fees, the licensing fees display a monotonic
pattern consistent with the pattern of the sharing incentives. Hence,
whether licensing fees have the same dynamics as the sharing incentives
depends on how impatient the firms are to reach the product market.
\subsection{Dynamics of Sharing When Firms Exit the Game \label%
{ex-post-sharing-exit}}
We next consider region B. In this region, a lagging firm may exit the game
if the leader does not share at some history. Competition in the product
market is sufficiently intense or research costs are sufficiently high so
that firms may exit when they fall behind. This introduces an important
strategic motive for a leading firm to refuse to share. Our question is
whether, in light of this, the pattern of sharing continues to satisfy the
monotonicity property. We find that this is not the case. A lagging firm may
be more likely to drop out earlier in the game, when it has more research
left to complete. Given this, a leading firm may be less likely to share
earlier in the game.
\begin{proposition}
\label{prop-non-monotonicity}In Region B, for an open set of parameters,
there is a MPE such that the firms share at $(2,1)$ but not at $(1,0)$,
where both histories arise on the equilibrium path.
\end{proposition}
The proposition is proved in the appendix. For a region of parameter values,
we demonstrate a unique equilibrium in which a non-monotonic sharing pattern
arises on the equilibrium path. The firms share at $(2,1),$ but they do not
share at $(1,0)$. This is because by not sharing at $(1,0),$ the firms can
reach the history $(2,0)$. At $(2,0)$, the firms do not share and the
lagging firm drops out. The leading firm then earns monopoly profits
forever. In the equilibrium, $(2,0;NS)$ is the only history at which the
lagging firm drops out. At $(2,1;NS)$ and $(1,0;NS)$, the lagging firm stays
in the race. Thus, the firms have a strong incentive to forego sharing at $%
(1,0)$ in order to reach $(2,0)$. A non-monotonic sharing pattern arises on
the equilibrium path when, after choosing not to share at $(1,0)$, the firms
next reach the history $(1,1)$ rather than $(2,0)$. The game then proceeds
to $(2,1)$ or $(1,2)$, at which point the firms share step $2$.
In a companion appendix, we solve for all of the equilibria of the model.%
\footnote{%
The appendix is available at
http://www.economics.unimelb.edu.au/nerkal/homepage/index.htm.} There, we
demonstrate another equilibrium where the monotonicity property fails. In
that equilibrium, the firms choose not to share at $(1,0)$ because then the
lagging firm immediately drops out. Because of this, the firms never reach
the history $(2,1)$ on the equilibrium path. They do share at $(2,1)$ off
the equilibrium path however, so technically the monotonicity property fails.
Figure \ref{equilibrium outcomes} depicts the equilibrium outcomes in the
case when we see non-monotonic sharing patterns both on and off the
equilibrium path.\footnote{%
There are multiple equilibria at $(0,0)$ in some of the regions. Both firms
can be in or both firms can be out at $(0,0)$. In the diagram, we selected
the equilibrium such that both firms invest at $(0,0)$. In the companion
appendix, some of the regions shown above are further divided because we
specify the sharing decision at $\left( 2,0\right) $ also.} The two regions
with the non-monotonic sharing pattern (NS,S) are separated by the vertical
line $\pi ^{D}=c\frac{r}{\alpha }\left( \frac{3}{2}+\frac{r}{2\alpha }%
\right) $. In the region to the left of this line, the lagging firm drops
out at the history $(1,0)$ if the firms do not share. Thus, an observer of
the game would not observe a non-monotonicity. In the region to the right of
the line, the lagging firm stays in the game at the history $(1,0)$ if the
firms do not share. Because of this, an observer of the game would observe a
non-monotonicity.
Although we have demonstrated how the possibility of drop out may result in
no sharing, it is important to note that it may also increase the incentives
to share. That is, the firms sometimes share at $(1,0)$ in Region B to keep
the lagging firm in the race. This happens on the left hand side of Figure %
\ref{equilibrium outcomes}, below the horizontal line $\pi ^{M}=c\frac{r}{%
\alpha }\left( 3+\frac{r}{\alpha }\right) $, where the sharing pattern is
(S,NS). The firms share at $(1,0)$ despite the fact that the lagging firm
would immediately drop out otherwise. Sharing enhances joint profits because
the lagging firm may finish the race faster than the leading firm, so that
monopoly profits are earned sooner. In this region, there are also multiple
equilibria at $(0,0)$, one where both firms invest and another one where
neither firms invests. When both firms invest, the firms benefit from each
other's presence because of future sharing at $(1,0)$ and $\left( 0,1\right)
$. But for this sharing, neither would have wanted to invest at $(0,0)$.
The left hand side of Figure \ref{equilibrium outcomes} also shows that if
the firms play a winner-take-all game, they may have incentives to share
early in the game. We interpret the game as a winner-take-all game when the
firms do not share at $(2,1)$ and the lagging firm then drops out. As can be
seen on the left hand side of Figure \ref{equilibrium outcomes}, we would
always expect the firms to share the first research step in this case. This
is because the firms will never compete as duopolists and they can maximize
joint profits by reaching the product market as quickly as possible. Sharing
allows them to achieve exactly this. It is important to point out that it is
not the level of spillovers which explains the sharing between the firms.
Rather, it is the dynamics of competition.
The results in sections \ref{ex-post-sharing-no-exit} and \ref%
{ex-post-sharing-exit} relate to a fundamental question in the economics of
R\&D on how competition affects the incentives for cooperation in R\&D. They
reveal that the dynamic impact of competition on cooperation is complex. The
sharing incentives may either increase or decrease throughout a research
process. In less competitive industries (where, as in Region A, the lagging
firm pursues duopoly profits rather than exiting), the firms will have
decreasing incentives to share. In more competitive industries (where, as in
Region B, the lagging firm exits at some histories), the firms may have
either decreasing or increasing incentives to share. As discussed in the
conclusion, these results have implications for government policy towards
sharing arrangements.
\section{$N$-step Research Process\label{N-step}}
In this section, we discuss some results obtained in a model with $N$
research steps of equal difficulty as robustness check. We focus on the main
question of whether the sharing patterns in Region A continue to be
monotonic. We first consider the case when $N=3$. Lemma \ref{lemma-region-A}
extends in a straightforward way and Region A is the set of parameters such
that the lagging firm stays in the game at the history $(3,0;NS)$.
Specifically, it is defined by $\pi ^{D}\geq c\frac{r}{\alpha }\left( 3+3%
\frac{r}{\alpha }+\frac{r^{2}}{\alpha ^{2}}\right) $.
The next proposition states how the result in Proposition \ref%
{prop-monotonicity} extends to a model with three research steps.
\begin{proposition}
\label{prop-N=3}Suppose $N=3$. In Region A, every MPE sharing pattern is
monotonic.
\end{proposition}
To prove the proposition, we derive the equilibria as we did for the case of
$N=2$. These derivations are available on request. With a three-step
research process, we can compare the sharing incentives at the histories
where the leader is one step ahead of the lagging firm (i.e., at $\left(
1,0\right) $, $\left( 2,1\right) $, and $\left( 3,2\right) $) as well as at
the histories where the leader is two steps ahead of the lagging firm (i.e.,
at $\left( 2,0\right) $ and $\left( 3,1\right) $). Proposition \ref{prop-N=3}
implies that both types of sharing patterns are monotonic. For the histories
$\left( 1,0\right) $, $\left( 2,1\right) $, and $\left( 3,2\right) $, there
exist parameter values where the equilibrium sharing decisions are (S,S,S),
(S,S,NS), (S,NS,NS) or (NS,NS,NS). For the histories $\left( 2,0\right) $
and $\left( 3,1\right) $, there exist parameter values where the equilibrium
sharing decisions are (S,S), (S,NS) or (NS,NS).\footnote{%
In Region A, when (\ref{Sharing at (2,1)}) holds, the unique MPE sharing
pattern is (S,S,S) if the gap between the firms is one ($g=1$) and (S,S) if $%
g=2$. When (\ref{Sharing at (2,1)}) fails, for small $\frac{r}{\alpha }$,
the unique MPE\ sharing pattern is (NS,NS,NS) for $g=1$ and (NS,NS) for $g=2$%
. As $\frac{r}{\alpha }$ increases, the unique MPE sharing pattern becomes
(S,NS,NS) for $g=1$ and (NS,NS) for $g=2$, then (S,S,NS) for $g=1$ and
(NS,NS) for $g=2$, and then (S,S,NS) for $g=1$ and (S,NS) for $g=2$.}
The sharing condition at all histories such that one firm is finished is
again given by (\ref{Sharing at (2,1)}). When this condition holds, the
firms share at the histories $(3,0),(3,1)$ and $(3,2)$. This removes the
possibility of monopoly profits, so the firms share at all earlier histories
also. The sharing condition at all earlier histories is given by (\ref%
{Sharing at (1,0) if S at (2,1)}). When (\ref{Sharing at (2,1)}) fails, the
firms do not share at $(3,0)$, $(3,1)$, or $(3,2)$. At all earlier histories
and in every equilibrium, the equilibrium sharing condition has the form
\begin{equation}
\beta (\pi ^{M}+c)+(1-\beta )(2\pi ^{D}-(\pi ^{M}-c))>0\text{,}
\label{general-sharing-condition}
\end{equation}%
where $\beta \in (0,1)$ depends on the history and the future sharing
decisions. In each equilibrium, when we compare the sharing conditions at
two histories with the same gap, we find that the value of $\beta $ is
higher at the earlier history. This gives us the monotonicity result.
The main intuition for this monotonicity result is the following. While the
firms jointly decide whether to share, the basic trade-off they face is
between maintaining the leader's lead so that he can earn monopoly profits
for longer period of time when he finishes first and enabling the lagging
firm to finish first at an earlier point in time. Note that at symmetric
histories, each firm has an ex ante 50\% chance of finishing first. When one
firm is ahead by one step, that firm has more than a 50\% chance of
finishing first. Because of this, the concern about keeping the leader's
lead has a greater weight in the decision than if the firms were in a
symmetric position. The monotonicity result follows because as the game
progresses, the weight put on this concern increases. That is, as the game
progresses, a lead of a fixed number of steps gives the leading firm a
greater chance of finishing first. To see this, note that at the history ($%
N,N-1$), since the leader is done, his lead gives him a 100\% chance of
finishing first. The sharing condition in this case places no weight on the
benefit of enabling the lagging firm to finish first ($\beta =0$) because
the lagging firm cannot finish first. When the game is longer, however, the
fact that the leader is one step ahead does not give him a 100\% chance of
finishing first. In fact, the longer is the game, the closer the leader's
chance of finishing is to 50\%.\footnote{%
Note that $\beta $ above is not literally the ex ante probability that the
lagging firm finishes first. It is a normalized, weighted discount factor
corresponding to changes in the flow of joint profits that occur when
sharing causes the lagging firm to finish earlier and before the leading
firm. When these changes occur earlier in time, they receive a higher weight.%
} Hence, there is a lower and lower weight placed on the concern about
keeping the leader's lead. Thus, the firms have increasing incentives to
share as we go back in time.
The monotonicity result cannot be strengthened to comparisons between
histories such that the leading firm is ahead by a differing number of
steps. For example, we find an equilibrium such that the firms share at $%
(2,1)$, but do not share at the earlier history $(2,0)$. The reason is that
at $(2,0)$, the leading firm is further ahead and has more to give up in
terms of forgone monopoly profits.
We expect that Proposition \ref{prop-monotonicity} could be extended further
to a model with $N$ research steps.\footnote{%
Note that Region A shrinks as $N$ increases because a lagging firm has a
lower payoff from staying in the game at $(N,0)$ than at $(N-1,0)$. Region B
grows as Region A shrinks since they are complementary sets.} However, we
have not proved this because the equilibrium calculations become too
cumbersome. Instead, we analyzed a related problem that we interpret as a
partial generalization of our monotonicity result. Consider any starting
history $(h+1,h)$ in the $N$-step model such that the leading firm is one
step ahead of the lagging firm. Assume that at all histories after $(h+1,h)$
the firms do not share and they also do not exit the game.\footnote{%
We know from the analysis in section 4.1 that if the firms always share in
the future, the sharing condition holds trivially because there is no cost
to sharing. We are considering the other extreme here and assume that the
firms never share in the future. This allows us to focus on the intuition
that the further away the firms are from the end of the research process,
the more uncertainty they face and the more willing they may be to share.}
Under this assumption, we can derive formulas representing the firms' joint
continuation payoffs and compare the continuation payoffs from sharing and
not sharing at $(h+1,h)$. The sharing condition always has the form (\ref%
{general-sharing-condition}), so we can define $\beta (h+1,h)$. Numerical
analysis reveals that $\beta (h+1,h)$ is decreasing in $h$ for $N\leq 20$.%
\footnote{%
We compared the payoffs by evaluating them on a discrete grid of parameter
values. The formulas appear to be sufficiently continuous that we do not
expect we missed any singularities in our simulations. The computations are
available on request.} This means that if the sharing condition holds at the
history $(h+1,h)$, then it holds at all earlier histories $(h^{\prime
}+1,h^{\prime })$ where $h^{\prime }c_{1}>0\text{, }\pi ^{M}>\pi ^{D}\geq 0\right\} $.
Since firm $2$ is the less efficient firm, Region A is defined by $\pi
^{D}\geq c_{2}\frac{r}{\alpha }\left( 2+\frac{r}{\alpha }\right) $.
Because of the cost asymmetry, sharing at the history $(h+g,h)$ no longer
implies sharing at the history $(h,h+g)$. In light of this, we now define a
sharing pattern as an ordered sequence of sharing decisions covering all
histories with the same gap \textit{and} with the same firm acting as the
leader. This implies, for $N=2$, there are two sharing patterns for each
equilibrium, one associated with each firm being the leader. The following
definition states the monotonicity property separately for each firm.
\begin{definition}
\label{definition-monotonicity-asymmetric}An equilibrium satisfies the
monotonicity property for firm $1$ (respectively for firm $2$) if whenever
the firms share at the history $(2,1)$ (respectively $(1,2)$), then they
also share at the earlier history $(1,0)$ (respectively $(0,1)$).
\end{definition}
We analyze whether both sharing patterns are monotonic in Region A, where
both firms invest at every history. Consider the histories $(2,1)$ and $%
(1,2) $. As in the previous analysis, the cost of sharing is $\pi ^{M}-2\pi
^{D}$. The sharing condition at $(2,1)$ is $c_{2}>\pi ^{M}-2\pi ^{D}$ and
the sharing condition at $(1,2)$ is $c_{1}>\pi ^{M}-2\pi ^{D}$. Because $%
c_{1}c_{1}$, and that the firms
have the same research cost in both stages of the research process. Then, in
Region A, every MPE sharing pattern is monotonic.
\end{proposition}
Proposition \ref{prop-monotonicity-asymmetry-1}, proved in the appendix,
states that sharing patterns continue to be monotonic even if the firms
differ in their research costs. As long as each firm's research costs do not
change over time, the firms receive higher joint benefits from sharing
earlier rather than later in the research process for essentially the same
reasons as in the symmetric model. The scenario that is most interesting to
consider is when, due to the asymmetry in their research costs, the firms
share at $(2,1)$ but not at $(1,2)$. This occurs when $c_{2}>\pi ^{M}-2\pi
^{D}>c_{1}$. For the sharing patterns where firm $1$ is the leader to be
monotonic, the firms must share at $(1,0)$ since they share at $(2,1)$. As
shown in the appendix, this is indeed the case. Intuitively, this can be
understood as follows. Because the firms share at $(2,1)$, firm $1$ does not
forego any future monopoly profits by sharing at $(1,0)$. On the other hand,
sharing at $(1,0)$ makes it more likely that firm $2$ will finish first.
Sharing also eliminates duplicative research on stage $1$. Thus, there is no
downside to sharing at $(1,0)$. Since the firms start to make joint flow
profits of $\pi ^{M}-c_{1}$ instead of $-\left( c_{1}+c_{2}\right) $, the
sharing condition at $\left( 1,0\right) $ is $\pi ^{M}+c_{2}>0$.
Since the firms do not share at $(1,2)$, it is trivially the case that all
sharing patterns with firm $2$ as the leader are monotonic. The sharing
condition at $(0,1)$, however, has some interest. From (\ref{sharing-at-0-1}%
) in the appendix, it is given by\
\begin{equation}
\beta (2\pi ^{D}+c_{1}+c_{2})+(1-\beta )(2\pi ^{D}-\pi ^{M}+c_{1})>0\text{,}
\label{Sharing-1-0-asymmetric-model1}
\end{equation}%
where $\beta =\frac{(\alpha +r)^{2}}{(2\alpha +r)^{2}}.$ The first term in (%
\ref{Sharing-1-0-asymmetric-model1}), $2\pi ^{D}+c_{1}+c_{2}$, is positive.
It arises because sharing at $(0,1)$ helps the firms reach $(2,1)$. At $%
(2,1),$ the firms share and joint flow profits increase from $-(c_{1}+c_{2})$
to $2\pi ^{D}.$ Sharing at $(0,1)$ thus brings about cost savings for both
firms. In particular, the higher is the leader's cost $c_{2}$, the greater
is the incentive to share. The second term in (\ref%
{Sharing-1-0-asymmetric-model1}) is negative because $\pi ^{M}-2\pi
^{D}>c_{1}$. This is the usual loss that arises when, due to sharing, the
lagging firm erodes the monopoly profits of the leading firm. In the
equilibrium, the benefit in the first term dominates the loss in the second
term, and the firms always share at $(0,1)$. Hence, future sharing at $(2,1)$
is sufficient to induce sharing at both of the earlier histories $(1,0)$ and
$(0,1)$ even though the firms do not share at $(1,2)$.
Next, we consider a different type of asymmetry, where one of the firms is
better at one stage of research than at the other stage of research.
Suppose, as above, that firm $1$ has a cost of $c_{1}$ in both stages, but
firm $2$ has a cost of $c_{2}^{1}$ in the first stage and $c_{2}^{2}$ in the
second stage. The only new asymmetry we introduce is in the research costs
of firm $2$. The model is now defined for $\Omega =\left\{ \left( \alpha
,r,c_{1},c_{2}^{1},c_{2}^{2},\pi ^{M},\pi ^{D}\right) \text{ such that }%
0<\alpha <1\text{, }00\text{, }c_{2}^{1}>0\text{, }%
c_{2}^{2}>0\text{, }\pi ^{M}>\pi ^{D}\geq 0\right\} $.
As above, we restrict our attention to Region A, where both firms invest at
every history. We find that all sharing patterns where firm $2$ is the
leader are monotonic although non-monotonicity may arise in sharing patterns
where firm $1$ is the leader.
\begin{proposition}
\label{prop-monotonicity-asymmetry-2}Suppose that the firms' research costs
are $\left( c_{1},c_{2}^{1}\right) $ in stage $1$ and $\left(
c_{1},c_{2}^{2}\right) $ in stage $2$. Then, in Region A, every MPE sharing
pattern with firm $2$ as the leader is monotonic. If $c_{2}^{1}\geqslant
c_{2}^{2}$, every MPE sharing pattern with firm $1$ as the leader is
monotonic. For some values of $c_{2}^{1}0\text{,} \label{sharing-at-1-0-asymmetric}
\end{equation}%
where $\beta =\frac{\alpha }{(3\alpha +r)}$. The new term $%
c_{2}^{1}-c_{2}^{2}$ captures the change in investment costs when the
lagging firm stops research on step $1$ and begins research on step $2$. If $%
c_{2}^{1}-c_{2}^{2}<0$, this is a loss and (\ref{sharing-at-1-0-asymmetric})
does not always hold. When (\ref{sharing-at-1-0-asymmetric}) fails, the
firms share at $(2,1)$ but not at $(1,0)$. By not sharing at $(1,0)$, the
firms prevent firm $2$ from starting to work on step $2$, where it would
incur high research costs. If firm $1$ subsequently completes step $2$, firm
$2$ will never have to work on it. The firms would attain even higher joint
profits if firm $2$ were simply to refrain from conducting further research
at $(1,0)$. However, by assumption, the firms cannot agree to this.
Hence, the analysis reveals that the impact of research costs on sharing
incentives depends on whether we are considering current or future research
costs. While an increase in the first-stage research cost of firm $2$, $%
c_{2}^{1}$, makes sharing at $\left( 1,0\right) $ more attractive, an
increase in the second-stage research cost, $c_{2}^{2}$, makes sharing at $%
\left( 1,0\right) $ less attractive. This contrasts with our comparative
statics conclusions from section \ref{ex-post-sharing-no-exit}, where an
increase in $c$ always made sharing more attractive.
These results extend the results under symmetry, showing that the
monotonicity result of section \ref{ex-post-sharing-no-exit} is not a
special phenomenon of symmetric environments. They describe what type of
sharing dynamics we would expect to see in industries where there is a
dominant research firm and in industries where different firms specialize in
different stages of the research process. In most of the cases we
considered, we have found that as firms approach the point of rivalry, their
incentives to cooperate break down. However, if the research costs of one of
the firms increase over time, the firms may choose not to share earlier on,
but choose to share later on when they are closer to product market
competition. Thus, changes in research costs over time may lead to sharing
dynamics that are not monotonic.
\section{Patent Policy\label{patent-policy}}
We next discuss the impact of patent policy on the dynamics of sharing. So
far we have assumed that once a firm successfully develops a research step,
it can either keep the technology secret or patent it. If there is
patenting, the lagging firm can develop a noninfringing technology that
serves the same purpose and continues to face the same research cost. In
this section, we assume that patenting increases the lagging firm's research
cost by forcing it to work around the patent of the leader. Stronger patent
policy (i.e., broader patent protection) may make it harder for rival firms
to invent around (Gallini, 1992).\footnote{%
The concept of patent scope has been interpreted in several different ways
in the literature on optimal patent policy. See Scotchmer (2004)\ for a
discussion of the different models.} Accordingly, we assume that a
strengthening of patent policy increases the lagging firm's research cost.
We show that stronger patent protection, as long as it does not cause exit
by the lagging firm, increases the incentives to share. However, if stronger
patent protection increases the incentives to exit, it may decrease the
incentives to share. Thus, as in our basic model, the incentives to drop out
play a crucial role in the results.\footnote{%
Bar (2006) and Fershtman and Markovich (2006)\ also explore the impact of
patent policy in a dynamic R\&D process, focusing on different research
questions. Bar (2006) studies the strategic incentives to publish R\&D
results in a dynamic R\&D process. Fershtman and Markovich (2006) study the
effects of different patent policy regimes on the speed of innovation in an
asymmetric dynamic R\&D race.}
We assume that both steps of the research process are patentable and, as
soon as a firm successfully completes a stage, it gets a patent. The firms
have symmetric costs $c$ at the histories $\left( 0,0\right) $ and $\left(
1,1\right) $, when they are working towards the same research step. After
one of the firms completes the next stage, the lagging firm cannot continue
to work on the same research path because doing so would imply infringement.
Hence, if it decides to stay in the game, it has two options. It can either
make a licensing deal with the leader or switch to a more expensive research
path with cost $c^{P}>c$. On this more expensive path, the firm invests to
complete the research process in a noninfringing way.\footnote{%
Hence, we assume that there are different research paths the firms can take
to achieve the same research outcome and the different research paths
correspond to different research costs. If one of the firms gets a patent,
the follower has to switch to another research path to avoid infringement.}
This set-up implies that the firms face asymmetric research costs at
asymmetric histories. While in section \ref{asymmetric-firms} we have
considered different types of firms, in this section we assume the firms are
symmetric to start with, but they become asymmetric as the game progresses
and the firms successfully develop the different research steps. We assume
that patenting in both stages affects the research cost of the lagging firm
in the same way by increasing it from $c$ to $c^{P}$.
As in the previous section, we focus on Region A and explore how the sharing
incentives change over time and when the sharing patterns are monotonic in
this region.\footnote{%
As in previous sections, Region A is defined by the drop out condition for
the lagging firm at the history $(2,0,NS)$. It is straightforward to show
that the lagging firm stays in the game at $(2,0,NS)$ if and only if $\pi
^{D}>c^{P}\frac{r}{\alpha }(2+\frac{r}{\alpha })$.} The derivations are
straightforward and available on request. Because the firms are not
inherently asymmetric, we use the same monotonicity definition as the one in
section \ref{sharing-dynamics}. The sharing condition at the histories $%
\left( 2,1\right) $ and $\left( 1,2\right) $ is given by
\begin{equation}
2\pi ^{D}-(\pi ^{M}-c^{P})>0. \label{Sharing at (2,1) if patenting}
\end{equation}%
This is also the sharing condition at $(2,0)$ and $(0,2)$. When (\ref%
{Sharing at (2,1) if patenting}) is satisfied, the firms share at all the
future histories after $(1,0)$ and $(0,1)$. The sharing condition at $\left(
1,0\right) $ and $\left( 0,1\right) $ is given by%
\begin{equation}
\beta (\pi ^{D}+c)+(1-\beta )\left( c^{P}-c\right) >0
\label{Sharing at (1,0) if patenting and S at (2,1)}
\end{equation}%
where $\beta =\frac{2\alpha }{4\alpha +r}$.\footnote{%
Note that when $c^{P}=c$, this is the same condition as in the symmetric
model.} The first term $\pi ^{D}+c$ is the same as in (\ref{Sharing at (1,0)
if S at (2,1)}), and is the benefit of sharing that arises when the lagging
firm finishes earlier due to sharing. The second term is also a gain since $%
c^{P}\geq c$. This is the change in the firms' joint flow profits which
arises when the lagging firm stops working to circumvent the patent on step $%
1$ and instead conducts research on step $2$. The condition (\ref{Sharing at
(1,0) if S at (2,1)}) holds trivially, so the monotonicity property holds.
Hence, sharing incentives decrease over time in environments where patenting
makes research more costly for the lagging firm.
A policy to strengthen patent protection causes an increase in the cost
parameter $c^{P}$. To analyze this, we consider how the cost parameter $%
c^{P} $ enters the sharing conditions (\ref{Sharing at (2,1) if patenting})
and (\ref{Sharing at (1,0) if patenting and S at (2,1)}). Since $c^{P}$
enters both conditions with a positive sign, a strengthening of patent
policy increases the benefits from sharing. This is because the policy
affects the lagging firm's outside option. Since the lagging firm has to
incur higher research costs following the patenting decision of the leader,
it will be willing to pay a higher licensing fee to the leader in exchange
for the technology. Hence, with broader patent protection, we would expect
the extent of sharing to increase because the firms can save on higher costs
of research.
This conclusion however may not always be true if a strengthening of patent
policy changes the investment decisions. If an increase in the lagging
firm's research cost $c^{P}$causes it to exit at some histories, we are in
Region B. Here, a strengthening in patent policy increases the incentive for
the lagging firm to exit. From the analysis in section \ref%
{ex-post-sharing-exit}, we know that the firms may decide against sharing to
cause the lagging firm to exit. This is because the leading firm upon
finishing will earn monopoly profits forever. In Region A, patents by
definition do not confer monopoly profits forever. It is possible that a
strengthening of patent policy would shift the game from Region A to Region
B. In this case, the policy could reduce the extent of sharing. Moreover, if
the new equilibrium is non-monotonic, sharing could break down early in the
research process even if it does not break down at the end. Thus, in
practice, predicting the effect of patent policy requires knowledge of
whether exit is likely (as in a winner-take-all environment) or whether
several firms could profitably pursue the research to its conclusion.
\section{Conclusion\label{conclusion}}
The paper considers the optimal pattern of knowledge sharing in the context
of technological competition. We have analyzed how the incentives to share
change over time as a research project reaches maturity. Developing a
theoretical foundation for optimal sharing strategies has important
implications for the design of optimal as well as efficient research
environments.
The results show that both how close the firms are to product market
competition and how intense that competition is shape the firms' sharing
behavior. If product market competition is moderate and the lagging firm is
expected never to drop out under rivalry, the incentives to share
intermediate research outcomes decreases monotonically with progress. If the
product market competition is intense and the lagging firm is expected to
drop out, the incentives to share may increase with progress.
The prevalence of sharing in early stages of research in certain industries,
often attributed to efficiencies of internalizing spillovers, could be due
in part to these competitive dynamics. Thus, to the extent that the
competitive dynamics matter, the propensity to share in early stages would
not indicate its higher value. The monotonicity result is also consistent
with the existing evidence that direct competitors choose to limit the scope
of their alliance to activities which can be considered to be further away
from the product market (Oxley and Sampson, 2004).
As robustness check, we have investigated whether the monotonicity result
continues to hold if we have an $N$-step research process, if the firms are
asymmetric, and if patenting increases the research cost of the lagging
firm. These results show us under what types of conditions we would expect
the monotonicity result to continue to hold. Specifically, we have shown
that the monotonicity result may be violated if there is asymmetry across
the different stages of research for one of the firms.
One assumption we have made in our analysis is that the lagging firm has no
bargaining power. Consider how a different distribution of bargaining power
between the two firms would affect the results. The distribution of
bargaining power does not affect the joint payoffs, but it affects the
individual payoffs. Hence, with a change in the firms' bargaining powers,
the incentives to share would not be affected, \textit{ceteris paribus},
because the sharing decisions are made based on joint profits. However,
since the individual payoffs of the firms would change, the investment
incentives would change. In particular, Region A (where neither firm drops
out at any of the histories) would expand to include more parameters because
the lagging firm would have a greater incentive to stay in the game.
Our results suggest new directions for empirical research on innovation.
Although there is a large literature on research alliances, there has been
little prior empirical research focusing on the dynamics of these alliances.
Our theoretical work focuses on the dynamics of sharing where the intensity
of product market competition, the difficulty of research, and the
impatience of firms are the key factors. Future research could address
whether these dynamics can be identified and empirically distinguished from
the impact of other dynamic variables, such as the intensity of spillovers,
financing issues, and the degree of antitrust risk, which are also likely
shape the patterns of sharing in industries where innovation is important.
The role played by each factor may depend on the industry and the nature of
the research.\footnote{%
For example, Lerner and Merges (1998) find that in the biotechnology
industry, it is the R\&D firms' need for financing which may cause alliances
to form at the earlier stages of research.}
Our results offer insights to guide policy-making in innovation
environments. Since the 1980s, governments in the US and in Europe have used
subsidies, tolerant antitrust treatment, and government-industry
partnerships to promote joint R\&D projects. Considering the dynamics of
sharing incentives and distinguishing between the factors which may shape
these incentives would help in determining under what circumstances such
policies are necessary and whether they should be directed towards early vs.
later stage research. If, as in our model, product market competition drives
the dynamics of sharing, the monotonicity result stated in Proposition \ref%
{prop-monotonicity} implies that in less competitive industries (where
lagging firms pursue duopoly profits rather than exiting), firms are likely
to have lower incentives to share in later stages of research than in early
stages. In this case, policies that encourage sharing in later stages when
private incentives to share are the weakest may have the greatest value. In
contrast, Proposition \ref{prop-non-monotonicity} implies that in more
competitive industries, such as industries with a winner-take-all structure,
firms may have lower incentives to share in early stages of research than in
later stages. In this case, policies that encourage sharing in early stages
in order to keep lagging firms in the market may have the greatest value.
\pagebreak
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\begin{center}
\appendix{\LARGE Appendix}
\end{center}
\section{Proof of Lemma \protect\ref{lemma-region-A} \label{proof-lemma-1}}
We must show that Region A consists of all parameters such that $\pi
^{D}\geq c\frac{r}{\alpha }\left( 2+\frac{r}{\alpha }\right) $. In a
companion appendix, we prove this by solving for all of the equilibria (see
footnote 17). Here, instead, we focus on the payoff that a firm would earn
by conducting two steps of research on its own and producing in the output
market as a duopolist. This is a lower bound on any firm's payoff at any
history and in any equilibrium. In Region A, the payoff of the lagging firm
at $\left( 2,0\right) $ equals this payoff. If the firms decide not to share
at $(2,0)$ and $(2,1)$, this is clearly the case. If the firms decide to
share at $(2,0)$ and $(2,1)$, then because the lagging firm has no
bargaining power, its payoff is the same as if they do not share.
We compute this payoff by working backwards. After completing the two steps
of research, the firm produces output as a duopolist to earn $\widetilde{\pi
}^{D}=\frac{\pi ^{D}}{r}$. To complete the second step of research, the firm
invests a flow cost of $c$ and in each instant the probability of success is
$\alpha $. The firm's expected payoff is $\int_{0}^{\infty }e^{-\left(
\alpha +r\right) t}\left( \alpha \widetilde{\pi }^{D}-c\right) dt=\frac{%
\alpha \widetilde{\pi }^{D}-c}{\alpha +r}$. To complete the first step of
research, the firm again invests a flow cost of $c$ and the hazard rate is
again $\alpha $. The firm's expected payoff is $\int_{0}^{\infty }e^{-\left(
\alpha +r\right) t}(\alpha \left( \frac{\alpha \widetilde{\pi }^{D}-c}{%
\alpha +r}\right) -cdt)=\frac{\alpha \left( \frac{\alpha \widetilde{\pi }%
^{D}-c}{\alpha +r}\right) -c}{\alpha +r}$. This payoff is strictly positive
if and only if
\begin{equation}
\pi ^{D}>c\frac{r}{\alpha }\left( 2+\frac{r}{\alpha }\right) \text{,}
\label{condition-region-A}
\end{equation}%
which is the inequality that defines Region A.
\section{Proof of Proposition \protect\ref{prop-monotonicity} \label%
{proof-prop-2}}
In Region A, by definition, no firm ever drops out of the game. To solve for
the MPE, we only need to determine whether firms share at the six asymmetric
histories. We derive the equilibrium sharing conditions for $(1,0),(2,0)$
and $(2,1)$. The three mirror histories $(0,1),(0,2),$ and $(1,2)$ have the
same analysis. To derive the sharing conditions, we use backwards induction
to solve for the MPE. To prove the proposition, we compare the equilibrium
sharing conditions at $(1,0)$ and $(2,1)$ for every MPE.
The last history is $(2,2).$ At $\left( 2,2\right) $, each firm produces
output and earns discounted duopoly profits of
\begin{equation}
V_{1}\left( 2,2\right) =V_{2}\left( 2,2\right) =\widetilde{\pi }^{D}.
\label{RegionA-profit-2-2}
\end{equation}%
Working backwards, the next history is $(2,1).$ The firms are willing to
share at $(2,1)$ iff this maximizes their joint profits. The sharing
condition (\ref{sharing-condition}) is
\begin{equation}
V_{J}\left( 2,2\right) >V_{J}\left( 2,1;NS\right) .
\label{RegionA-sharing-2-1-formal}
\end{equation}%
Joint profits under sharing are $V_{J}\left( 2,2\right) =V_{1}\left(
2,2\right) +V_{2}\left( 2,2\right) =2\widetilde{\pi }^{D}.$ Joint profits
under no sharing are%
\begin{equation}
V_{J}\left( 2,1;NS\right) =V_{1}\left( 2,1,NS\right) +V_{2}\left(
2,1,NS\right) =\frac{\pi ^{M}+2\alpha \widetilde{\pi }^{D}-c}{\alpha +r}%
\text{,} \label{RegionA-joint-profits-2-1-NS}
\end{equation}%
where%
\begin{equation*}
V_{1}\left( 2,1;NS\right) =\frac{\pi ^{M}+\alpha V_{1}\left( 2,2\right) }{%
\alpha +r}=\frac{\pi ^{M}+\alpha \widetilde{\pi }^{D}}{\alpha +r}
\end{equation*}%
since firm 1 earns monopoly profits until firm 2 completes the second step
and
\begin{equation}
V_{2}\left( 2,1;NS\right) =\frac{\alpha V_{2}\left( 2,2\right) -c}{\alpha +r}%
=\frac{\alpha \widetilde{\pi }^{D}-c}{\alpha +r} \label{RegionA-profit-2-1}
\end{equation}%
since firm $2$ invests until it completes the second step.
The sharing condition (\ref{RegionA-sharing-2-1-formal}) simplifies to $2%
\widetilde{\pi }^{D}(\alpha +r)>\pi ^{M}+2\alpha \widetilde{\pi }^{D}-c$ or%
\begin{equation}
2\pi ^{D}-(\pi ^{M}-c)>0 \label{RegionA-sharing-2-1}
\end{equation}%
This condition holds, strictly fails, or holds as an equality. We consider
each possibility in turn.
\textbf{Case 1:\ The sharing condition at (2,1) holds. }For parameter values
such that the sharing condition (\ref{RegionA-sharing-2-1}) holds, the firms
share step 2 at $\left( 2,1\right) $. Before considering the sharing
decision at $\left( 1,0\right) $, we need to see whether the firms share
step 1 at $(2,0)$. The sharing condition (\ref{sharing-condition}) is $%
V_{J}\left( 2,1\right) >V_{J}\left( 2,0;NS\right) $. Joint profits under
sharing are $V_{J}\left( 2,1\right) =V_{J}\left( 2,2\right) =2\widetilde{\pi
}^{D}$ since the firms share at $(2,1)$ after sharing at $(2,0).$ Joint
profits under no sharing are
\begin{eqnarray*}
V_{J}\left( 2,0;NS\right) &=&V_{1}\left( 2,0;NS\right) +V_{2}\left(
2,0;NS\right) \\
&=&\frac{\pi ^{M}+\alpha V_{1}\left( 2,1\right) }{\alpha +r}+\frac{\alpha
V_{2}\left( 2,1\right) -c}{\alpha +r}=\frac{\pi ^{M}+\alpha V_{J}\left(
2,1\right) -c}{\alpha +r}=\frac{\pi ^{M}+\alpha 2\widetilde{\pi }^{D}-c}{%
\alpha +r}\text{.}
\end{eqnarray*}%
The sharing condition $V_{J}\left( 2,1\right) >V_{J}\left( 2,0;NS\right) $
simplifies to
\begin{eqnarray*}
2\widetilde{\pi }^{D}\left( \alpha +r\right) &>&\pi ^{M}+2\alpha \widetilde{%
\pi }^{D}-c \\
c &>&\pi ^{M}-2\pi ^{D}.
\end{eqnarray*}%
This is condition (\ref{RegionA-sharing-2-1}), which we have assumed to
hold. Hence, the firms share step 1 at $\left( 2,0\right) $. The joint
payoffs are $2\widetilde{\pi }^{D}$.
At $(1,0)$, the sharing condition (\ref{sharing-condition}) is $V_{J}\left(
1,1\right) >V_{J}\left( 1,0;NS\right) .$ Joint profits under sharing are $%
V_{J}\left( 1,1\right) =2V_{1}\left( 1,1\right) $ where%
\begin{equation}
V_{1}\left( 1,1\right) =\frac{\alpha V_{1}\left( 1,2\right) +\alpha
V_{1}\left( 2,1\right) -c}{2\alpha +r}=\frac{\alpha V_{J}\left( 2,1\right) -c%
}{2\alpha +r}=\frac{2\alpha \widetilde{\pi }^{D}-c}{2\alpha +r}
\label{RegionA-profit-1-1}
\end{equation}%
Joint profits under no sharing are
\begin{equation*}
V_{J}\left( 1,0;NS\right) =\frac{\alpha V_{J}\left( 2,0\right) +\alpha
V_{J}\left( 1,1\right) -2c}{2\alpha +r}=\frac{2\alpha \widetilde{\pi }%
^{D}+\alpha V_{J}\left( 1,1\right) -2c}{2\alpha +r}\text{.}
\end{equation*}%
The sharing condition simplifies to%
\begin{equation}
\left( 2\alpha +r\right) V_{J}\left( 1,1\right) >2\alpha \widetilde{\pi }%
^{D}+\alpha V_{J}\left( 1,1\right) -2c\text{.}
\label{RegionA-sharing-1-0-case1}
\end{equation}%
Substituting for $V_{J}\left( 1,1\right) $ in (\ref%
{RegionA-sharing-1-0-case1}) we get
\begin{equation}
\pi ^{D}+c>0\text{,} \label{RegionA-sharing-1-0-case1-simplified}
\end{equation}%
which is trivially true. This proves the monotonicity result for all
parameter values for which the sharing condition (\ref{RegionA-sharing-2-1})
holds. In the unique MPE for these parameter values, the firms share at $%
(2,1)$ and $(1,0)$. The sharing pattern is (S,S).
\textbf{Case 2. The sharing condition at (2,1) fails strictly.} For
parameter values such that the sharing condition (\ref{RegionA-sharing-2-1})
strictly fails, the firms do not share at $(2,1)$. Before considering the
sharing decision at $(1,0),$ we need to see whether the firms share at $%
(2,0) $. The sharing condition (\ref{sharing-condition}) is $V_{J}\left(
2,1\right) >V_{J}\left( 2,0;NS\right) .$ Joint profits are under no sharing
are
\begin{eqnarray*}
V_{J}\left( 2,0;NS\right) &=&V_{1}\left( 2,0;NS\right) +V_{2}\left(
2,0;NS\right) \\
&=&\frac{\pi ^{M}+\alpha V_{1}\left( 2,1\right) }{\alpha +r}+\frac{\alpha
V_{2}\left( 2,1\right) -c}{\alpha +r}=\frac{\pi ^{M}+\alpha V_{J}\left(
2,1\right) -c}{\alpha +r}\text{.}
\end{eqnarray*}%
The sharing condition simplifies to\
\begin{equation*}
V_{J}\left( 2,1\right) >\frac{\pi ^{M}+\alpha V_{J}\left( 2,1\right) -c}{%
\alpha +r}
\end{equation*}%
Since the firms do not share at $\left( 2,1\right) $, we can substitute for $%
V_{J}\left( 2,1\right) $ from (\ref{RegionA-joint-profits-2-1-NS}).
Simplifying, we get $c>\pi ^{M}-2\pi ^{D}$. This is the same as condition (%
\ref{RegionA-sharing-2-1}) which does not hold. Hence, the firms do not
share step $1$ at $(2,0).$
At $(1,0),$ the sharing condition (\ref{sharing-condition}) is $V_{J}\left(
1,1\right) >V_{J}\left( 1,0;NS\right) .$ Joint profits under no sharing are
\begin{equation}
V_{J}\left( 1,0;NS\right) =\frac{\alpha V_{J}\left( 2,0\right) +\alpha
V_{J}\left( 1,1\right) -2c}{2\alpha +r}\text{.}
\label{Region2-joint-profit-1-0-NS}
\end{equation}%
The sharing condition simplifies to $\left( \alpha +r\right) V_{J}\left(
1,1\right) >\alpha V_{J}\left( 2,0\right) -2c$. We can substitute for $%
V_{J}\left( 1,1\right) =2V_{2}\left( 1,1\right) $. We have
\begin{equation*}
V_{J}\left( 1,1\right) =2\frac{\alpha V_{2}\left( 1,2\right) +\alpha
V_{2}\left( 2,1\right) -c}{2\alpha +r}=2\frac{\alpha V_{J}\left( 2,1\right)
-c}{2\alpha +r}=2\frac{\alpha (\pi ^{M}+2\alpha \widetilde{\pi }%
^{D})-c(2\alpha +r)}{(2\alpha +r)(\alpha +r)}\text{,}
\end{equation*}%
where the last equality follows from (\ref{RegionA-joint-profits-2-1-NS}).
Since there is no sharing at either $\left( 2,0\right) $ or $\left(
2,1\right) $, we use (\ref{RegionA-joint-profits-2-1-NS}) to get
\begin{equation*}
V_{J}\left( 2,0\right) =\frac{\pi ^{M}+\alpha V_{J}\left( 2,1\right) -c}{%
\alpha +r}=\frac{\left( 2\alpha +r\right) \pi ^{M}+2\alpha ^{2}\widetilde{%
\pi }^{D}-c\left( 2\alpha +r\right) }{\left( \alpha +r\right) ^{2}}\text{.}
\end{equation*}%
Substituting for $V_{J}\left( 1,1\right) $ and $V_{J}\left( 2,0\right) $,
the sharing condition simplifies to%
\begin{equation}
c>(\pi ^{M}-2\pi ^{D})-\frac{2(\alpha +r)^{2}}{(2\alpha +r)^{2}}(\pi
^{M}-\pi ^{D}). \label{RegionA-sharing-1-0-case2}
\end{equation}%
Since $\pi ^{M}>\pi ^{D}$, this condition is easier to satisfy than (\ref%
{RegionA-sharing-2-1}). For parameter values such that the sharing condition
(\ref{RegionA-sharing-1-0-case2}) holds, there is a unique MPE such that the
firms share at $(1,0)$ but not at $(2,1)$. The sharing pattern is (S,NS).
For parameter values such that the sharing condition (\ref%
{RegionA-sharing-1-0-case2}) strictly fails, there is a unique MPE such that
the firms do not share at either $(1,0)$ or $(2,1)$. The sharing pattern is
(NS,NS). For parameter values such that the sharing condition (\ref%
{RegionA-sharing-1-0-case2}) holds with equality, there are two MPE that
differ based on whether the firms choose S or NS at $(1,0)$. The sharing
pattern is either (S,NS) or (NS,NS).
\textbf{Case 3. The sharing condition at (2,1) holds with equality. }When $%
c=\pi ^{M}-2\pi ^{D}$, the firms are indifferent between sharing and not
sharing at $(2,1)$. We know from above that the sharing condition at $(2,0)$
is the same as the sharing condition at $(2,1)$, so the firms are
indifferent between sharing and not sharing at $(2,0)$. There are multiple
equilibria because the firms may choose either S or NS at $(2,0)$.
Regardless of their choices, the sharing condition at $(1,0)$ is given by
both (\ref{RegionA-sharing-1-0-case1-simplified}) and (\ref%
{RegionA-sharing-1-0-case2}) which coincide and hold trivially. Hence, the
sharing pattern is either (S,NS) or (S,S).
\section{Calculation of the licensing fees\label{licensing-fees-calculation}}
The leading firm sets the licensing fee according to equation (\ref%
{licensing-fee}), so that the lagging firm is just indifferent between
sharing and not sharing. At $(2,1),$ the licensing fee is%
\begin{equation}
F(2,1)=V_{2}\left( 2,2\right) -V_{2}\left( 2,1;NS\right) =\frac{\pi ^{D}+c}{%
\alpha +r} \label{RegionA-fee-2-1}
\end{equation}%
where the last equality makes use of (\ref{RegionA-profit-2-2})\ and (\ref%
{RegionA-profit-2-1}). At $(1,0),$ the licensing fee is
\begin{equation*}
F(1,0)=V_{2}\left( 1,1\right) -V_{2}\left( 1,0;NS\right) .
\end{equation*}%
We can substitute for $V_{2}\left( 1,1\right) $ from (\ref%
{RegionA-profit-1-1}). $V_{2}\left( 1,0;NS\right) $ is given by%
\begin{equation}
V_{2}\left( 1,0;NS\right) =\frac{\alpha V_{2}\left( 1,1\right) +\alpha
V_{2}\left( 2,0\right) -c}{2\alpha +r}\text{.} \label{RegionA-profit-1-0-NS}
\end{equation}%
Since the lagging firm has no bargaining power at $(2,0)$, its profit is $%
V_{2}\left( 2,0;NS\right) $ even though the firms share at $\left(
2,0\right) $. Similarly, its profit at $(2,1)$ is $V_{2}\left( 2,1;NS\right)
$ even though the firms share at $(2,1)$. Using (\ref{RegionA-profit-2-1}),
we have
\begin{equation*}
V_{2}\left( 2,0\right) =V_{2}\left( 2,0;NS\right) =\frac{\alpha V_{2}\left(
2,1\right) -c}{\alpha +r}=\frac{\alpha ^{2}\widetilde{\pi }^{D}-c\left(
2\alpha +r\right) }{\left( \alpha +r\right) ^{2}}
\end{equation*}%
Hence, $F(1,0)$ simplifies to
\begin{equation*}
F(1,0)=\left( \frac{\pi ^{D}+c}{\alpha +r}\right) \left( \frac{5+6\frac{r}{%
\alpha }+2(\frac{r}{\alpha })^{2}}{4+8\frac{r}{\alpha }+5(\frac{r}{\alpha }%
)^{2}+(\frac{r}{\alpha })^{3}}\right) .
\end{equation*}%
Comparing the fees $F(1,0)$ and $F(2,1)$, we find that $F(2,1)>F(1,0)$ iff $%
\frac{r}{\alpha }$ is above a cut-off of approximately $\frac{r}{\alpha }%
\cong 0.325.$
\section{Proof of Proposition \protect\ref{prop-non-monotonicity} \label%
{proof-prop-3}}
We solve for the equilibria of the game for all parameter values in a
companion appendix (see footnote 17). Here, we derive the non-monotonic
equilibrium discussed in the paper. In the companion appendix, this region
is labeled as Region 6. The equilibria for other parameter values are solved
similarly.
We solve the game in the following region of parameters:\ $c\frac{r}{\alpha }%
\left( \frac{3}{2}+\frac{r}{2\alpha }\right) <\pi ^{D}V_{J}(2,1;NS)$.
The payoff $V_{J}(2,1;NS)$ depends on whether firm $2$ invests. If firm $2$
invests at $(2,1;NS),$ its continuation profit is\
\begin{equation}
V_{2}\left( 2,1;NS\right) =\frac{\alpha \widetilde{\pi }^{D}-c}{\alpha +r}.
\label{profit-2-1-NS}
\end{equation}%
This payoff is positive because by assumption $\pi ^{D}>c\frac{r}{\alpha }$.
Hence,\ firm $2$\ invests at $(2,1;NS)$.
Since firm $2$ invests at $(2,1;NS),$ the analysis of the sharing condition
is the same as the one in section (\ref{proof-prop-2}), we do not repeat
here. The firms share at $\left( 2,1\right) $ iff (\ref{RegionA-sharing-2-1}%
) holds. This condition holds in this region and the firms share step $2$\
at $(2,1)$.
At the history $(1,1)$, each firm has one success. There is no sharing
decision to be made. The firms must, however, decide whether to invest to
develop the second step. Assuming firm $1$ invests, firm 2 will also invest
if
\begin{equation*}
V_{2}\left( 1,1\right) =\frac{\alpha V_{2}\left( 2,1\right) +\alpha
V_{2}\left( 1,2\right) -c}{2\alpha +r}=\frac{\alpha V_{J}\left( 2,1\right) -c%
}{2\alpha +r}>0\text{.}
\end{equation*}%
Since the firms share at $(2,1)$, $V_{J}\left( 2,1\right) =2\widetilde{\pi }%
^{D}.$ Substituting we get
\begin{equation}
V_{2}\left( 1,1\right) =\frac{2\alpha \widetilde{\pi }^{D}-c}{2\alpha +r}>0%
\text{,} \label{profit-1-1}
\end{equation}%
which simplifies to $\pi ^{D}>\frac{cr}{2\alpha }$. Since this condition
holds by assumption in this region, firm $2$ invests. Hence, each firm
invests at $(1,1)$ if the other does.
If firm $1$ does not invest at $(1,1)$, the new history is $(X,1)$. Firm 2
invests if
\begin{equation}
V_{2}\left( X,1\right) =\frac{\alpha V_{2}\left( X,2\right) -c}{\alpha +r}=%
\frac{\alpha \widetilde{\pi }^{M}-c}{\alpha +r}>0\text{,} \label{profit-1-X}
\end{equation}%
where $V_{2}\left( X,2\right) =\widetilde{\pi }^{M}$ because\ firm $2$\
produces output as a monopolist at $(X,2)$. The condition simplifies to $\pi
^{M}>c\frac{r}{\alpha }$, which holds because $\pi ^{M}>\pi ^{D}$and in this
region $\pi ^{D}>c\frac{r}{\alpha }$. Hence, firm 2 invests at $(X,1)$. It
follows that both firms invest at $(1,1)$.
At the history $(2,0),$the sharing condition is $V_{J}(2,1)>V_{J}(2,0;NS)$.
The payoff $V_{J}(2,0;NS)$ depends on whether firm $2$ invests. Firm 2
invests iff%
\begin{equation*}
V_{2}\left( 2,0;NS\right) =\frac{\alpha V_{2}\left( 2,1\right) -c}{\alpha +r}%
>0.
\end{equation*}%
We know from Lemma \ref{lemma-region-A} that this condition simplifies to
\begin{equation*}
\pi ^{D}>c\frac{r}{\alpha }\left( 2+\frac{r}{\alpha }\right) \text{,}
\end{equation*}%
which fails in this region, so firm $2$\ drops out at $(2,0)$ if the firms
do not share.
At $(2,0),$ joint profits under sharing are $V_{J}\left( 2,1\right) =2%
\widetilde{\pi }^{D}$ since if the firms share, the game reaches the history
$(2,1)$ and the firms share step $2$. Joint profits under no sharing are $%
V_{J}\left( 2,0;NS\right) =V_{1}\left( 2,X\right) =\widetilde{\pi }^{M}$
since firm $2$ drops out of the game if the firms do not share. Thus, the
sharing condition at $(2,0)$ simplifies to
\begin{equation}
2\pi ^{D}-\pi ^{M}>0 \label{RegionB-sharing-2-0}
\end{equation}%
In this region, we have that $\pi ^{M}>2\pi ^{D}$. Hence, the firms do not
share at $(2,0)$. The lagging firm then drops out of the game.
Working backwards from either $(2,0)$ or $(1,1),$ we next consider the
history $(1,0)$. At this history, firm $1$ has one success and firm $2$ has
no successes. The sharing condition is $V_{J}(1,1)>V_{J}(1,0;NS)$. The
payoff $V_{J}(1,0;NS)$ depends on whether each firm invests. If firm 1
invests, firm 2 also invests if%
\begin{equation}
V_{2}\left( 1,0;NS\right) =\frac{\alpha V_{2}\left( 1,1\right) +\alpha
V_{2}\left( 2,0\right) -c}{2\alpha +r}>0 \label{profit-1-0}
\end{equation}%
We can substitute for $V_{2}\left( 1,1\right) $ from (\ref{profit-1-1}).
Moreover, $V_{2}\left( 2,0\right) =0$ since the firms do not share at $(2,0)$
and the lagging firm drops out. After substituting and simplifying, (\ref%
{profit-1-0}) becomes%
\begin{equation*}
\pi ^{D}>c\frac{r}{\alpha }\left( \frac{3}{2}+\frac{r}{2\alpha }\right)
\text{.}
\end{equation*}%
This holds in the region, so the lagging firm $2$ invests at $\left(
1,0;NS\right) $ if firm $1$ does. It is straightforward to show that the
leading firm $1$ also invests at $\left( 1,0;NS\right) $ if firm $2$
invests. If firm $2$ does not invest, the history becomes $\left( 1,X\right)
$ and the leading firm invests as shown above. It follows that the leading
firm invests at $\left( 1,0;NS\right) $ whether or not the lagging firm
invests. Thus, both firms invest at $\left( 1,0;NS\right) $.
At $(1,0),$ joint profits under no sharing are%
\begin{equation}
V_{J}\left( 1,0;NS\right) =\frac{\alpha V_{J}\left( 2,0\right) +\alpha
V_{J}\left( 1,1\right) -2c}{2\alpha +r}=\frac{\alpha \widetilde{\pi }%
^{M}+\alpha V_{J}\left( 1,1\right) -2c}{2\alpha +r}.
\label{joint-profits-1-0}
\end{equation}%
The sharing condition, $V_{J}(1,1)>V_{J}(1,0;NS)$, simplifies to
\begin{equation*}
\alpha \widetilde{\pi }^{M}+\alpha V_{J}\left( 1,1\right) -2c<\left( 2\alpha
+r\right) V_{J}\left( 1,1\right)
\end{equation*}%
Substituting for $V_{J}(1,1)=2V_{2}\left( 1,1\right) $ from (\ref{profit-1-1}%
) and simplifying, the sharing condition at $(1,0)$ is%
\begin{equation}
\pi ^{M}<2\pi ^{D}\left( \frac{2\alpha +2r}{2\alpha +r}\right) +c\left(
\frac{2r}{2\alpha +r}\right) \text{.} \label{RegionB-sharing-1-0}
\end{equation}%
This inequality fails in the region, so the firms do not share at $(1,0)$.
At the history $(0,0)$, assuming firm $2$ invests, firm $1$ will also invest
if%
\begin{equation*}
V_{1}\left( 0,0\right) =\frac{\alpha V_{1}\left( 1,0;NS\right) +\alpha
V_{1}\left( 0,1;NS\right) -c}{2\alpha +r}=\frac{\alpha V_{J}\left(
1,0;NS\right) -c}{2\alpha +r}>0
\end{equation*}%
Substituting from (\ref{joint-profits-1-0}) and (\ref{profit-1-1}), we get%
\begin{equation*}
4\alpha \pi ^{D}+\left( 2\alpha +r\right) \pi ^{M}>\left( 4\alpha +r\right)
\left( 2\alpha +r\right) \frac{r}{\alpha ^{2}}c+2cr\text{.}
\end{equation*}%
Since $\pi ^{M}>2\pi ^{D}$ in this region, the condition holds if%
\begin{equation*}
\left( 8\alpha +2r\right) \pi ^{D}>\left( 4\alpha +r\right) \left( 2\alpha
+r\right) \frac{r}{\alpha ^{2}}c+2cr\text{.}
\end{equation*}%
Since $\pi ^{D}>c\frac{r}{\alpha }\left( \frac{3}{2}+\frac{r}{2\alpha }%
\right) $ in this region, the condition holds if%
\begin{equation*}
\left( 8\alpha +2r\right) \left( \frac{3}{2}+\frac{r}{2\alpha }\right) \frac{%
r}{\alpha }c>\left( 4\alpha +r\right) \left( 2\alpha +r\right) \frac{r}{%
\alpha ^{2}}c+2cr\text{.}
\end{equation*}%
This simplifies to $2\alpha \left( 2\alpha +r\right) >0$, which always
holds. Hence, firm $1$ invests at $(0,0)$ if firm $2$ invests.
Assuming firm $2$ does not invest, the history becomes $(0,X)$. Firm $1$
invests if
\begin{equation*}
V_{2}(0,X)=\frac{\alpha V_{2}(1,X)-c}{\alpha +r}=\frac{\alpha \left( \frac{%
\alpha \widetilde{\pi }^{M}-c}{\alpha +r}\right) -c}{\alpha +r}>0\text{,}
\end{equation*}%
where we have substituted for $V_{2}(1,X)$ from (\ref{profit-1-X}).
Simplifying we get
\begin{equation}
\pi ^{M}>c\frac{r}{\alpha }(2+\frac{r}{\alpha }). \label{stay-in-X-0}
\end{equation}%
In this region, we have that $\pi ^{M}>2\pi ^{D}$ and $\pi ^{D}>c\frac{r}{%
\alpha }\left( \frac{3}{2}+\frac{r}{2\alpha }\right) $. These two conditions
together imply that (\ref{stay-in-X-0}) holds. Hence, firm $1$\ invests at $%
(0,X)$. It follows that\ both firms invest at $(0,0)$. This completes the
derivation of the equilibrium. The equilibrium is unique.
\section{Proof of Proposition \protect\ref{prop-monotonicity-asymmetry-1}}
The proof is a straightforward generalization of our results for Region A of
the basic model.\footnote{%
Region A is the set of parameters such that $\pi ^{D}\geq \frac{c_{2}r}{%
\alpha }(2+\frac{r}{\alpha })$. This condition is the drop out condition for
firm $2$ (the inefficient firm) at the history $(2,0)$. The proof is similar
to Lemma \ref{lemma-region-A}.} To save space, we do not present a complete
proof. Instead, we focus on the subregion of Region A where, due to the
asymmetry in their research costs, the firms share at $(2,1)$, but not at $%
(1,2)$.\footnote{%
When the firms do not share at either $(2,1)$ or $(1,2)$, the sharing
pattern is monotonic regardless of the sharing decisions at $(1,0)$ and $%
(0,1)$. When the firms share at both\ $(2,1)$ and $(1,2)$, the derivation of
the result is a straightforward generalization of the symmetric case.} We
solve the game backwards. At $(2,1)$, the sharing condition is $V_{J}\left(
2,2\right) >V_{J}\left( 2,1;NS\right) $. This yields%
\begin{equation*}
2\widetilde{\pi }^{D}>V_{J}\left( 2,1;NS\right) =\frac{\pi ^{M}+\alpha 2%
\widetilde{\pi }^{D}-c_{2}}{\alpha +r}\text{.}
\end{equation*}%
This simplifies to $c_{2}>2\pi ^{D}-\pi ^{M}$. Similarly, the firms share
at\ $(1,2)$ if $c_{1}>2\pi ^{D}-\pi ^{M}$. From now on we consider the
subregion of Region A such that $c_{2}>\pi ^{M}-2\pi ^{D}>c_{1}$. In this
subregion, the firms share at $(2,1)$, but not at $(1,2)$. At $(2,0)$, the
sharing condition is\
\begin{equation*}
V_{J}\left( 2,1\right) >V_{J}\left( 2,0;NS\right) =\frac{\pi ^{M}+\alpha
V_{J}\left( 2,1\right) -c_{2}}{\alpha +r}.
\end{equation*}%
Using $V_{J}\left( 2,1\right) =2\widetilde{\pi }^{D}$, this simplifies to $%
c_{2}>2\pi ^{D}-\pi ^{M}$. This holds, so the firms share at $(2,0)$.
At\ $(0,2)$, the sharing condition is
\begin{equation*}
V_{J}\left( 1,2\right) >V_{J}\left( 0,2;NS\right) =\frac{\pi ^{M}+\alpha
V_{J}\left( 1,2\right) -c_{1}}{\alpha +r}\text{.}
\end{equation*}%
Using
\begin{equation*}
V_{J}\left( 1,2\right) =V_{J}\left( 1,2;NS\right) =\frac{\pi ^{M}+\alpha 2%
\widetilde{\pi }^{D}-c_{1}}{\alpha +r}\text{,}
\end{equation*}%
the sharing condition simplifies to $c_{1}>2\pi ^{D}-\pi ^{M}$. This does
not hold, so the firms do not share at $(0,2).$
At $\left( 1,0\right) $, the sharing condition is $V_{J}\left( 1,1\right)
>V_{J}\left( 1,0;NS\right) .$ Joint profits at $(1,1)$ are%
\begin{equation}
V_{J}\left( 1,1\right) =\frac{\alpha V_{J}\left( 2,1\right) +\alpha
V_{J}\left( 1,2\right) -c_{2}-c_{1}}{2\alpha +r}\text{.}
\label{joint-profits-at-1-1}
\end{equation}%
Joint profits at $(1,0;NS)$ are%
\begin{equation*}
V_{J}\left( 1,0;NS\right) =\frac{\alpha V_{J}\left( 1,1\right) +\alpha
V_{J}\left( 2,0\right) -c_{2}-c_{1}}{2\alpha +r}.
\end{equation*}
Substituting for $V_{J}\left( 2,0\right) =V_{J}\left( 2,1\right) =2%
\widetilde{\pi }^{D}$ and $V_{J}\left( 1,2\right) =V_{J}\left( 1,2,NS\right)
=\frac{\pi ^{M}+\alpha 2\widetilde{\pi }^{D}-c_{1}}{\alpha +r},$ the sharing
condition at $(1,0)$ simplifies to $\pi ^{M}+c_{2}>0$. This holds trivially,
so the firms share at $(1,0)$. Thus, the monotonicity property holds for
firm $1$ in the subregion.
Because the firms do not share at $(1,2),$ the monotonicity property holds
for firm $2$ whether or not the firms share at $(0,1)$ in the subregion. The
sharing condition at $(0,1)$ is $V_{J}\left( 1,1\right) >V_{J}\left(
0,1;NS\right) $ where
\begin{equation*}
V_{J}\left( 0,1;NS\right) =\frac{\alpha V_{J}\left( 1,1\right) +\alpha
V_{J}\left( 0,2\right) -c_{2}-c_{1}}{2\alpha +r}.
\end{equation*}
Using (\ref{joint-profits-at-1-1}) and substituting for $V_{J}\left(
2,1\right) =2\widetilde{\pi }^{D}$, $V_{J}\left( 1,2,NS\right) =\frac{\pi
^{M}+\alpha 2\widetilde{\pi }^{D}-c_{1}}{\alpha +r},$ and $V_{J}\left(
0,2\right) =V_{J}\left( 0,2,NS\right) =\frac{\pi ^{M}+\alpha V_{J}\left(
1,2\right) -c_{1}}{\alpha +r},$ the sharing condition at $(0,1)$ simplifies
to%
\begin{equation*}
c_{2}(\alpha +r)^{2}+(2\pi ^{D}+c_{1})(2\alpha +r)^{2}-\pi ^{M}\alpha
(3\alpha +2r)>0\text{.}
\end{equation*}%
This can be rewritten as%
\begin{equation}
\frac{(\alpha +r)^{2}}{(2\alpha +r)^{2}}(2\pi ^{D}+c_{1}+c_{2})+(1-\frac{%
(\alpha +r)^{2}}{(2\alpha +r)^{2}})(2\pi ^{D}+c_{1}-\pi ^{M})>0\text{.}
\label{sharing-at-0-1}
\end{equation}%
It is straightforward to show using the other constraints that define this
subregion that condition (\ref{sharing-at-0-1}) always holds. Thus, the
firms share at $(1,0)$ and the sharing pattern is (S,NS).
\section{Proof of Proposition \protect\ref{prop-monotonicity-asymmetry-2}}
The proof is a straightforward generalization of our results for Region A of
the basic model.\footnote{%
Here, Region A is the set of parameters such that $\pi ^{D}\geq \max \{\frac{%
c_{1}r}{\alpha }(2+\frac{r}{\alpha }),\frac{c_{2}^{1}r}{\alpha }(1+\frac{r}{%
\alpha })+\frac{c_{2}^{2}r}{\alpha }\}$. When this condition holds, firm $1$
does not drop out at\ $(0,2)$ and firm $2$ does not drop out at $(2,0)$. The
proof is a straightforward generalization of Lemma \ref{lemma-region-A}.} To
save space, we do not present a complete proof. Instead, we show why the
monotonicity property for firm $1$ does not always hold in Region A and
derive the equations discussed in the text.
We solve the game by working backwards through the histories. At $(2,1)$,
the sharing condition is\
\begin{equation*}
V_{J}\left( 2,2\right) >V_{J}\left( 2,1;NS\right) =\frac{\pi ^{M}+\alpha 2%
\widetilde{\pi }^{D}-c_{2}^{2}}{\alpha +r}\text{.}
\end{equation*}%
Using $V_{J}\left( 2,2\right) =2\widetilde{\pi }^{D}$, this simplifies to $%
2\pi ^{D}-(\pi ^{M}-c_{2}^{2})>0.$Similarly, the firms share at $(1,2)$ if
and only if $2\pi ^{D}-(\pi ^{M}-c_{1})>0.$ From now on, we consider the
subregion of Region A where both of these conditions hold, so the firms
share at $(2,1)$ and $(1,2)$. We have $V_{J}\left( 2,1\right) =V_{J}\left(
1,2\right) =2\widetilde{\pi }^{D}.$
At $(2,0)$, the sharing condition is\
\begin{equation*}
V_{J}\left( 2,1\right) >V_{J}\left( 2,0;NS\right) =\frac{\pi ^{M}+\alpha
V_{J}\left( 2,1\right) -c_{2}^{1}}{\alpha +r}\text{.}
\end{equation*}%
Using $V_{J}\left( 2,1\right) =2\widetilde{\pi }^{D}$, this simplifies to $%
2\pi ^{D}-(\pi ^{M}-c_{2}^{1})>0$. From now on, we assume this also holds so
that the firms share at $(2,0)$. Similarly, the firms share at $(0,2)$ iff $%
2\pi ^{D}-(\pi ^{M}-c_{1})>0$. This is the same condition as the condition
for sharing at $(1,2)$, so it holds. So the firms share at $(2,0)$ and $%
(0,2) $. We have $V_{J}\left( 2,0\right) =V_{J}\left( 0,2\right) =2%
\widetilde{\pi }^{D}$.
The monotonicity property for firm $1$ holds if and only if the firms share
at $(1,0).$ The sharing condition is $V_{J}\left( 1,1\right) >V_{J}\left(
1,0;NS\right) $. The joint payoff at $(1,1)$ is \
\begin{equation*}
V_{J}\left( 1,1\right) =\frac{\alpha V_{J}\left( 2,1\right) +\alpha
V_{J}\left( 1,2\right) -c_{2}^{1}-c_{1}}{2\alpha +r}=\frac{4\alpha
\widetilde{\pi }^{D}-c_{2}^{1}-c_{1}}{2\alpha +r}\text{.}
\end{equation*}%
The joint payoff at $(1,0;NS)$ is%
\begin{equation*}
V_{J}\left( 1,0;NS\right) =\frac{\alpha V_{J}\left( 2,0\right) +\alpha
V_{J}\left( 1,1\right) -c_{2}^{2}-c_{1}}{2\alpha +r}\text{.}
\end{equation*}%
Substituting for $V_{J}\left( 2,0\right) =2\widetilde{\pi }^{D}$ and $%
V_{J}\left( 1,1\right) $, the sharing condition simplifies to%
\begin{equation}
(2\pi ^{D}+c_{1}+c_{2}^{2})+(c_{2}^{1}-c_{2}^{2})(\frac{2\alpha +r}{\alpha }%
)>0\text{.} \label{sharing-at-1-0-asymmetric2}
\end{equation}%
A sufficient condition for sharing at $(1,0)$ is that $c_{2}^{1}-c_{2}^{2}>0$%
. However, there are parameters in this subregion such that $%
c_{2}^{1}-c_{2}^{2}<0$ and the sharing condition fails. The firms do not
share at $(1,0)$ and the equilibrium is not monotonic.
\end{document}