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We offer a simple model of patent settlement for examining how litigation prospects, patent strength and expected damage awards affect consumer benefits stemming from settlement agreements providing for per-unit royalties and non-negative fixed fees. The result shows that consumers may be harmed if expected damage payments forgone by settlement lead to agreements with high royalty payments that benefit both the patent holder and licensee at the expense of the consumer.
By using a very simple model of patent settlement, we show that a licensing agreement to settle a patent dispute can harm consumers in comparison with the expected outcome of the lawsuit. This may occur when the challenger’s expected return from litigation is low, that is when probabilistic damages are high relative to the challenger’s expected profits from competing on the same technological footing with the incumbent. In these circumstances, the royalty rate proposed by the patent holder in its take-itor-leave-it licensing offer may be so high as to drive the consumer surplus from settlement below the expect surplus from litigation. If the two firms are Bertrand competitors selling a homogeneous product, the patent holder can act as a monopolist whatever the strength of its patent. This is due to the fact that under this kind of competition the threat of probabilistic liability forces the challenger to stay out of the market even if the probability of patent infringement is close to zero. In this case, consumers suffer the highest possible losses from the lack of a decision on patent infringement. Since consumers’ losses are very relevant when the patent involved is weak, our model suggests that there may be large benefits to reap from “better examining commercially significant patents” in circumstances other than those identified by Farrell and Shapiro (2008, p. 1361).