A significant strand of literature has analyzed the problem of an external innovator who licenses a superior technology to one or many firms competing in the market. This article contributes to that debate by analyzing licensing to firms with different efficiency levels. Novel questions arise when one takes heterogeneity in the ex-ante firms' characteristics into consideration. Moreover, the traditional modeling technique of process innovation as a linear cost-reducing parameter ceases to have economic soundness. This paper aims to find an alternative modeling solution that accounts for diversity in firms' efficiency.
Assuming a per-unit linear price licensing scheme (royalty), I show that the external innovator is subject to two distinct forces: a price effect (PE) and a market share effect (MSE). The former describes the inefficient firms' willingness to pay for a cost-reducing technology. The latter describes the market penetration of the new technology - i.e., the level of output produced with the innovative process. On the one hand, the innovator wants to set the largest royalties possible. On the other hand, she wants to achieve the most significant market penetration, which implies many royalties. When PE dominates MSE, the least efficient firms get the innovation. Vice-versa, the most efficient firms get the license. If the innovator cannot exclude firms from purchasing the innovation, then, starting from the less efficient firms, the number of licensees increases as the MSE gets more intense.