Licensing intellectual property with self-reported outcomes

The licensing of intellectual property (IP) is growing dramatically. A distinguishing feature of licensing versus standard sales is that license contracts often involve self-reporting; the licensor relies on the licensee to report the royalties owed. This study examines self-reporting licensing contracts using a game-theoretic approach to royalty compliance. A licensee's accounting system generates a potentially inaccurate royalty report provided to the licensor. This self-reporting gives rise to demand for auditing by the licensor. We characterize the optimal royalty contract, accounting system choice by the licensee, and audit strategy choice by the licensor. We find that self-reporting either (a) limits the licensee's rents, but lowers social welfare, or (b) enhances social welfare by facilitating use of the IP by the low-cost licensee instead of the high-cost licensor. As accounting system costs decrease or the gains from outsourcing increase, variable royalties based on self-reporting become even more desirable.