Technology transfer with moral hazard

This paper develops an incomplete contract model of the licensing relationship that is susceptible to the moral hazard problem. The optimal contractual form of licensing derived in the model generates predictions that seem to be consistent with actual practice. For instance, the introduction of inputs that are not contractible and costly explains the prevalence of royalty contracts in the licensing relationship. Moreover, the model is able to relate the size of the royalty rate to the parameters that represent the environments under which the concerned parties operate. Finally, the model can be naturally extended to analyze the choice of a technology holder between direct investment and licensing in an attempt to serve a foreign market. (C) 2001 Elsevier Science B.V. All rights reserved.