A Real Options Model of Patent Litigation

We develop a real options model to examine the factors influencing potential outcomes of patent disputes from a corporate finance perspective. By investigating the dynamic strategic interactions between a patent-owning incumbent and an allegedly infringing challenger, we find that intense competition from the challenger's market entry, high product market volatility, and a larger disparity in the two firms' willingness to engage in litigation make settlement less likely. Under the English rule, where the loser pays, the challenger's relative willingness to engage in litigation increases compared to the American rule, where each party bears its own costs. This shift results in lower royalty rates in settlements. Our model offers insights into litigation and settlement rates, the effects of legal rules, and post-dispute market structures, highlighting how these outcomes are shaped by product market characteristics.