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An Incumbent and Challenger's Options In Patent Litigation Under Different Legal Rules

We build a compound real options model to study the dynamic strategic interactions between a patent-owning incumbent firm and a challenger firm in a patent dispute. New to the literature, we consider the challenger's option to exit the market during litigation because of the high litigation cost, and the incumbent's option to withdraw from an ongoing litigation or to force the challenger out of the market by a threat of litigation. Our model uncovers the two firms' similar willingness to pay for the litigation facilitates their settlement (in the form of royalty payment). We find novel results regarding how the product market characteristics and patent rules affect the likelihood, timing, and terms of settlement. The challenger’s profit gain relative to the incumbent’s loss of profits due to the alleged infringement (``gain-to-loss ratio'') has to be high for settlements to be possible and settlement is less likely in more volatile product markets. In addition, the English rule (of loser pays) shifts the effective bargaining power from the incumbent to the challenger, compared to the American rule (of each party pays). Such a shift can cause an opposite effect of patent validity on settlement likelihood for countries using the English rule (positive effect) vs. the American rule (negative effect). Our model generates new testable implications for the litigation rate and the settlement rate in patent disputes from a finance perspective.