Risk sharing in licensing

This paper studies the design of linear license contracts under demand or cost uncertainty. The optimal contract consists, in general, of a mix of a fixed fee and royalties. The source of uncertainty has a crucial impact on the type of royalties that must be used. In particular, under demand uncertainty at most two of the instruments are used. The contract generally combines a fixed fee with an ad valorem royalty. When cost is uncertain, a wider variety of cases can arise. The contract may involve a combination of either type of royalties, coupled with a fixed fee. Alternatively, it may be optimal to use all three available instruments.