Product innovation in a vertically differentiated model

We study the licensing incentives of an independent input producer owning a patented product innovation which allows the downstream rms to improve the quality of their nal goods. We consider a general two-part tari¤ contract for both outside and incumbent innovators. We nd that technology di¤usion critically depends on the nature of market competi- tion (Cournot vs. Bertrand). Moreover, the vertical merger with either downstream rm is always privately pro table and it is welfare improving for large innovations: this implies that not all pro table mergers should be rejected.