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62 Hold-up problem and asymmetric information in the technology

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					Hold-ups and Asymmetric Information in a Technology Transfer:

                         the Micronas Case




                              Klaus Kultti

           Department of Economics and Management Science,

        Helsinki School of Economics and Business Administration

                P.O. BOX 1210, 00101 Helsinki, Finland

                             kultti@hkkk.fi



                            Tuomas Takalo*

                       Department of Economics

           P.O. BOX 54, 00014 University of Helsinki, Finland

                       tuomas.takalo@helsinki.fi




                                   1
Abstract



In 1980 three Finnish companies established a research joint venture as a separate firm in

order to develop semiconductors. We study the initial stages of the project focusing on

the two evident sources of difficulty associated with an international technology transfer.

One is a hold-up problem and the other asymmetric information on the quality of the

technology. We develop two simple models that capture some features of the contract

governing the technology transfer, and conclude that both problems were present, but

hold-up problems were considered a more serious threat.



JEL Classification: O31, O32, O34, L15, L63




                                            2
1. Introduction



Incomplete contracting is regarded as a prevalent feature of real-life business

relationships, and there is plenty of theoretical work on its consequences, too (for surveys,

see Hart, 1995, and Tirole, 1999). Systematic empirical evidence, however, is scant. We

employ the relatively abundant data1 on a Finnish research joint venture, Micronas, to

study a seemingly incomplete contract associated with a transfer of semiconductor

technology. In particular, we evaluate whether hold-up problems originating from non-

verifiability of actions or asymmetric information about the quality of the technology was

a greater impediment to the technology transfer.

       In 1980 three Finnish companies Nokia, Aspo, and Salora established a research

joint venture called Micronas in order to develop semiconductors. Underlying the project

was the transition in the semiconductor industry. Until the late 70s semiconductors were

rather homogenous products that were available from numerous manufacturers. In the late

70s it became evident that in the future an increasing amount of semiconductors will be

application-specific. In other words the degree of product differentiation was changing.

The world-wide demand for semiconductors was also outrunning production capacity.

The prospects at least in the minicomputer industry were favourable in that the total

market for computer semiconductors of $900 million in 1980 had been estimated to grow

20-25 percent a year. As against other countries with a significant electronics industry,

Finland had no semiconductor business of its own, which worried both the venture

partners and policy-makers. The firms did not consider it desirable to rely solely on


                                             3
foreign suppliers and technology; they and the policy-makers believed that semiconductor

manufacturing would be integrated so that companies in the electronics industry would

make their own semiconductors.

       The initial technology was bought and transferred from an American company,

Micro Power Systems Inc. (MPSI), which was selected amongst nearly twenty companies.

The contract with MPSI was detailed and complicated, including equity participation

clauses. Even so, co-operation with MPSI ran into difficulties because of disagreements

about the interpretation of the contract. The research joint venture also encountered

various other troubles, and as a consequence its ownership structure changed several

times. Neither as a joint venture nor as Nokia’s subsidiary Micronas was ever profitable

(see Figure 1). Finally, after years of dismal economic performance, it was sold to an

outside party in 1992, who rapidly rendered Micronas economically viable, by 1994 net

profits were considerable. Nevertheless, some goals of the project, like the acquisition of

the relevant know-how and the establishment of a semiconductor company in Finland

were achieved. Nokia considers know-how in semiconductor design essential, and

Micronas’s semiconductor plant is still in Finland and supplies semiconductors for

several Finnish companies, including Nokia.

       In this article we focus on the initial stages of the project, in particular on the

technology transfer. For a comprehensive account of the events after the technology

transfer was completed, we refer the reader to Kultti and Takalo (2000). Theory suggests

two relevant problems with technology transfer. The literature on patent licensing

emphasises asymmetric information about the quality of the technology, making the

market for technology incomplete. In a typical model such as Gallini and Wright (1990),


                                            4
the licensor knows more about its technology than the potential licensee, and tries to

signal the quality of the technology through contract design.

        Another branch of literature focuses on the hold-up problem that arises from the

impossibility of complete contracting (see, e.g., Williamson, 1975, and Hart, 1995). The

contracting parties make relationship-specific investments that increase the value of their

output. The investments are assumed non-verifiable which means that the parties’ shares

of the output are determined in bargaining only after the investment costs are sunk. In

bargaining each party must share the return on his investment. This leads to

underinvestment.

        Our aim is to relate the theories stemming from asymmetric information and hold-

up problems to a real contract of technology transfer that was made between MPSI and

Nokia (which subsequently guaranteed Micronas free use of the license). The technology

of MPSI was rather unusual and, as a result, the problem of asymmetric information on

the quality of technology was evident. The hold-up problem was caused by the fact that

the value of the technology depended on the training that MPSI provided to Micronas.

The training is a relationship-specific investment, and its quality difficult to verify. Nokia

did not want to pay for the technology and training up-front since in that case it would not

receive the quality it wanted. MPSI did not want to train the personnel of Micronas before

the payment because the payment could not be made conditional on the non-verifiable

quality of the training.

        The hold-up problem can be solved by a contract where the payments come in

multiple stages. The agreement between Nokia and MPSI also included such a staggered

fee schedule. Unfortunately, it transpires that the problems arising from asymmetric


                                              5
information can be solved by a similar contract. Thus, by solely examining the contract,

we cannot determine whether the hold-up or asymmetric information was the

fundamental problem. This suggests that the received theories concerning these problems

ignore some crucial aspects of contracting. We have to resort to evidence from the actual

transfer process to conclude that both hold-up problems and asymmetric information were

present but that hold-up problems were a more serious concern.

       We describe the events associated with the technology transfer in section 2. A part

of the contract of the technology transfer is reproduced in section 3. Of particular interest

in the contract is the fee schedule. In section 4 the fee schedule is employed as the

principal element in assessing the predictions of the theories. We first consider the

contract form arising from incomplete contract theory and then the contractual practise

corresponding the asymmetric information. Our study culminates in section 5 in which we

provide a systematic evaluation of the events. The concluding remarks are in section 6.



2. The description of the technology transfer



In this section we briefly summarise the history of the technology transfer. We try to

avoid drawing our own conclusions about these events, postponing them to the following

sections. When referring to Nokia we mean Nokia Mobira, the predecessor of Nokia

Mobile Phones, originally a joint venture with Salora but since June 1982 a subdivision

of Nokia.

       In the late 70’s Salora, during that time the leading Nordic television manufacturer

and the largest firm in the electronics industry in Finland, perceived that they needed


                                             6
sufficient know-how to design and manufacture application-specific semiconductors.

Even though the project was initiated by the private sector, the role of Government was

significant in the initial stages of the project. Salora asked SITRA, the Finnish National

Fund for Research and Development, for financial and technical support. To secure an

adequate financial and technological base for the project, SITRA enticed Nokia, then the

second-largest Finnish firm in the electronics industry, to join the project. Yet, a third

private company, Aspo, showed interest in semiconductor technology and joined the

project. Aspo was a multiproduct company with a turnover of 530 Million FIM and 692

employees in 1979. It principally provided logistical services, and had at the time

expanded its operations to electronics industry, particularly the manufacture of hybrid

circuits.2 Besides SITRA, another governmental organisation influencing the launch of

the project was VTT, the Technical Research Centre of Finland. There had been a

semiconductor laboratory in VTT since the mid-60’s and VTT provided some of the

initial human capital and the equipment.

       The preliminary research of establishing a Finnish company in the semiconductor

industry was made during 1979. This research was conducted jointly with the three

private companies and VTT. It aimed to answer the question of how to acquire suitable

basic technology and training in the design and manufacture of semiconductors to render

the Finnish venture partners capable of developing the technology further for their special

purposes. More specifically, the Finnish parties desired to obtain the right and capability

to use LSI (large scale integration)-technology. The chips based on LSI-technology have

1.000-100.000 components, and they were displacing the chips with a smaller scale of

integration (SSI and MSI) in the late 70’s. There was no need to acquire the necessary


                                            7
machines and personnel from the same source as the technology. By that time the

equipment in design and manufacture of semiconductors based on LSI-technology were

standardised, and they could be obtained from specialised suppliers. If the training were

bought, the personnel could be obtained from Finland. It was also thought that VTT could

provide the testing laboratory and personnel.

       As usual, the choice was the one of making or buying. The parties opted for the

latter solution and decided to buy a license to a basic technology as well as the relevant

training. In addition to the supposed swiftness of this alternative, Nokia’s successful

experience of this imitation-and-development strategy directed the choice.3 The parties

contacted nearly twenty firms around the world (see Table I), before settling on a smallish

Californian firm Micro Power Systems Inc. (MPSI) and its bipolar linear and CMOS

(complementary metal-oxide semiconductor) technologies. These technologies were

rather unusual as they enabled the manufacture of mixed-signal integrated circuits. Such

circuits combine both digital and analogue functions in one circuit. MPSI was owned by

Japanese company SEIKO (70%), the manager (15%) and other employees (15%), and its

annual turnover was about 10 million US$ and it had 240 employees in 1979.

       MPSI agreed to transfer the relevant technological information as well as to

provide training in semiconductor design and manufacture. The Finnish venture partners

agreed that Nokia will acquire the technology and place it in the free use of Micronas.

The intention was that MPSI would serve as a sub-contractor until a plant was built in

Finland. MPSI was also interested in entering the agreement, because its customers feared

to be locked into its unique technology. To alleviate this problem, MPSI needed a second




                                            8
source, and Micronas would have been a suitable one. In other words, MPSI expected that

if the plant is eventually built, Micronas will become a subcontractor for MPSI.

        The negotiations between Nokia and MPSI were tough. The original contract was

signed in 26th June 1980 but almost immediately after that Seiko required amendments,

especially concerning the right of MPSI to the improvements created by its technology. A

new contract was signed 28th August 1980. The contract and its amendments are

described in detail in the next section.

        During the negotiations MPSI offered Nokia an opportunity to invest in MPSI.

Nokia seized the opportunity: a part of the contract was that Nokia became the third

largest owner of MPSI, acquiring 11.45 % of its shares. The key reason for this

exceptional feature was that Nokia wanted to secure a member in the MPSI’s board of

directors. It was thought that this would guarantee the smoothness of the transfer process.

Nonetheless, in 1981 when the transfer process started, the Finnish and American parties

ran into trouble. According to Micronas’s engineers, MPSI did not show strong

commitment to training, and the technology turned out to be slightly less suitable than

Micronas has expected. MPSI was also unwilling to modify the technology, and the

necessary changes had to be made by Micronas. A report on the training by Micronas’s

technical director illustrates the situation:



“In the view of this writer, it was necessary to start the training well before the date of the

first payment 30.6.1981, because it was to be feared that MPSI’s incentive to provide the

training would be weakened, after the payment would be made. Probably this would have

happened…During the training session it became evident that the performance of MPSI’s


                                                9
integrated circuits was insufficient for all needs of the partners…MPSI clearly retarded

the training…” (Translated from Finnish by the authors)”



        Despite the difficulties, the first patent based on the purchased technology was

granted to Micronas in 1983, and by the end of that year the transfer of the technology

was completed. At this stage the Finnish firms made a detailed plan to build the

semiconductor plant in Finland. When the final decision on the building was made, the

share capital of Micronas was increased as two new partners joined the RJV. One was a

Finnish company, Kone, a leading figure in the global elevator and escalator business,

and the other was MPSI. We next reproduce a part of the actual contract of the technology

transfer.




3. The contract



In addition to the ownership arrangement explained in the previous section a substantial

part of the agreement made in June 1980 consists of the training programmes on how to

design, manufacture, and market semiconductors. For our purposes the key consideration

of the agreement is the fee schedule:4



a) US$600,000 within 60 days from commencement of training provided for in Section

2.2 above (design training), but in no event later than December 15, 1980;




                                           10
b) US$300,000 within 60 days from commencement of the training under Section 2.3

(manufacture training), but in no event later than June 30, 1981;



c) US$325,000 within 60 days from commencement of assistance provided under Section

2.5 above (assistance in plant construction) but in no event later than December 31, 1983;

provided, however, that Nokia shall be excused from the payment of US$162,500, if it has

not requested the assistance provided for under Section 2.5 above by December 31, 1983.

It is understood that if Nokia commences the construction of a semiconductor facility by

December 31, 1986, MPSI is entitled to the full payment provided in Subsection (c) above

notwithstanding.



The provisions for the quality of training in the contract are rather general. The design

training was the most important part of the transfer, and is hence specified in the greatest

detail in the contract.



2.2. DESIGN TRAINING. Commencing approximately October 1980, MPSI at its plant

will train up to five qualified engineers by Nokia in the design techniques employed by

MPSI in the design of semiconductors utilizing CMOS and bipolar linear technology. As

part of this training, MPSI will provide design rules, existing cell design and training in

application of these rules and designs. The documentation which will be provided will

include the “cell library” which contains information regarding the design function,

characteristics and applicability of specific cells. The objective of the design training is




                                            11
to prepare the Nokia engineers to design integrated circuits in bipolar and high density

CMOS technology.



It may be hard to verify to a third party, say, when ‘the Nokia engineers’ are sufficiently

‘prepared to design integrated circuits’. As training is difficult to measure, the possibility

of the hold-up problem arises.

       The hold-up problems already manifested themselves in the negotiations. They

appeared almost immediately after Nokia had made a relationship-specific investment

that included the choice of MPSI as the trading partner and the information acquisition of

MPSI’s technology. The original contract on technology transfer between MPSI and

Nokia in June 1980 was silent about treatment of the licensed technology after the

transfer is successfully completed. The contract was, however, soon amended according

to the requirements of Seiko, MPSI’s principal shareholder. The major amendments were

the clauses concerning confidentiality and the disclosure of improvements in technology

by Nokia. In brief, in the confidentiality clause Nokia agreed to keep strictly confidential

all technology disclosed by MPSI and to take appropriate actions to guarantee the secrecy.

Similarly, the disclosure clause entitled MPSI a non-exclusive, royalty-free licence, to

make, use and sell all improvements and developments of the licensed technology which

Nokia might make. Nokia also agreed to advise MPSI of these improvements.

       The emergence of these hold-ups in the early stage of the licensing process can be

interpreted in terms of the ‘fundamental transformation’ in Williamson (1985, 1989). By

the ‘fundamental transformation’ Williamson refers to a change in the contracting

environment from an auction like situation to a bargaining like situation. The original


                                             12
contract between MPSI and Nokia was based on an offer submitted in a bidding

competition. After Nokia had chosen MPSI as a trading partner and had begun

specialising in the technology of MPSI, Seiko and MPSI clearly gained bargaining power.

Eventually Seiko and MPSI managed to alter the licensing contract to their advantage.

Although this transformation of the contracting environment would be worth studying in

detail, our analysis focuses on the fee schedule (a)-(c), because they are a central concern

in the theory of technology transfer.




4. Hold-up problem and asymmetric information



The prior research has discovered two primary sources of difficulty associated with the

technology transfer. One is the hold-up problem, and the other asymmetric information on

the quality of the technology. We consider the problems separately in two models familiar

in the literature. First we discuss the situation with no asymmetric information but just the

hold-up problem in an incomplete contract model that resembles Hart (1995).5 We then

evaluate the situation with no hold-up problem but asymmetric information about the

quality of the technology in a formal model inspired by Gallini and Wright (1990). The

solution to both problems gives rise to a kind of contract that Nokia and MPSI actually

made.




                                             13
4.1 The hold-up problem without asymmetric information



There are two elements in the hold-up problem. First, there must be some relationship-

specific assets, i.e., assets whose value in the relationship is higher than in any alternative

use. Secondly, investments in the relationship must be non-verifiable, i.e., no contract

contingent on the investment can be made, since it is not enforceable in court.

Consequently, the profits from the project are shared only after the investments are made,

and the parties cannot guarantee that they receive the full return on their investments. If

simple spot contracts were the only feasible contracts the whole project would probably

not be realised. The problems may, however, be alleviated by more complicate

arrangements; it turns out that the optimal contract features obligations in multiple stages.

       The advantage of staggered payments over the spot contract can be seen in a

simple example of a two-stage technology transfer. The value of the technology depends

on the amount and quality of training that MPSI offers to Nokia. If Nokia pays for the

licence and the training at the beginning of the first period, MPSI has no incentive to use

its resources on training. As training is hard to measure, it is safe to assume that its level

and quality are not verifiable in court, and consequently payments or other obligations

cannot be enforced contingent on it. Payment at the beginning of the first period would

mean that Nokia receives insufficient training.

       As one can see from section 3, the agreement between Nokia and MPSI is more

elaborate than a spot contract. It resembles an option contract where the seller holds the

right but not the obligation to complete the delivery, and the payment of the buyer is

contingent on the delivery decision of the seller. In the present case the option contract


                                              14
works as follows: MPSI agrees to train Nokia’s employees during period one, and at the

beginning of period two, when Nokia observes the quality of training, it has an

opportunity to buy the licence at a certain price. Nokia uses the option only if the quality

of training is sufficient, which gives MPSI the correct incentives to offer training.




4.2 Asymmetric information without hold-up problems



We assume that Nokia’s information about the technology or the training offered is much

worse than that of MPSI. To take the simplest case let us assume that the technology can

be either good or bad, and that MPSI knows the quality of its technology perfectly. This

uncertainty may cause the market for the technology to break down completely as in some

adverse selection models, or it may just make the price of the technology far too low from

MPSI’s perspective. The prevailing view in the literature, e.g., in Gallini and Wright

(1990), Macho-Stadler and Pérez-Castrillo (1991), Begg (1992) and Wright (1993), is that

the extensive use of royalties in licensing contracts is a response to asymmetric

information about the quality of technology. The idea is to set the output-based royalty so

high that a licensee produces and incurs the royalties only if the licensed technology is

sufficiently good. A licensor with a poor technology is unwilling to offer such a contract,

because the licensee would find it unprofitable to produce and the licensor would be left

without the output-based payments. The contract between Nokia and MPSI does not

include royalties, yet its simple fee schedule seems to serve the same purpose of

eliminating the problem of asymmetric information.


                                             15
       In the appendix we show formally that there is a solution to the problem of

asymmetric information that only depends on two dates, while an output-based royalty is

conditional on aggregate production. It also imposes little informational requirements on

the licensee’s output. A firm with good quality technology, that is, MPSI, can signal the

true quality of its product by the contract form. MPSI takes the payment in two stages; at

the first stage it agrees to deliver the product for some small fee, possibly even free of

charge. At the second stage the true quality of the product is revealed. If the product turns

out to be good quality, MPSI receives an additional payment that corresponds to at least

the value of a poor product. Lest Nokia refuse to make the additional payment, it does not

receive the licence. The first payment has to be low enough for low-quality firms not to

offer the contract since they know that they will get only the first part of the payment.

This theory thus also predicts that the payments are staggered as in the agreement

between Nokia and MPSI.




5. Evaluation



The agreement and the actual transfer process seem to indicate that both hold-up

problems and asymmetric information were present in the technology transfer. For

instance, both problems are evident from the quote from the report on the training given

in section 2. We first discuss the possibility that asymmetric information was the major

source of the difficulties. We then pursue an alternative interpretation that the contract

was structured to avoid hold-up problems.


                                             16
       Because one of the main purposes of the project was to acquire knowledge of the

methods and techniques of semiconductor design and manufacturing, almost by definition

there must have initially been a substantial informational gap between the potential sellers

of the technology and the Finnish venture partners. The Finnish firms tried to bridge this

gap by forming a team from their best experts of the technology. The leader had been

conducting research at the Standford University, and he used his contacts to obtain

information on available technologies. This team was responsible for both the initial

project evaluation and the selection of the MPSI’s technology. Government experts from

VTT, the Technical Research Centre of Finland, were also included in the team, but their

role was more prominent in the evaluation than in the selection stage.

       It is relatively awkward to assess the level of knowledge of this team. On the one

hand, it is tempting to regard the poor performance of Micronas (see Figure 1) as

resulting from the choice of bad technology. There are indeed a few documents indicating

that Micronas had problems to render the performance of its circuits satisfactory: Even as

late as 1986 Nokia classified Micronas (at that time Micronas was already Nokia’s

subsidiary) and the availability of high-quality semiconductors as a weakness in the

SWOT analysis (Strengths, Weaknesses, Options, Threats). A government expert

involved in the project said in our interview:



“I think that MPSI simply used the opportunity to earn some extra cash by exploiting the

poorly informed Finnish firms”.




                                             17
On the other hand, it is clear that the buyers of the technology were convinced about its

quality. There are at least two factors supporting the view that hold-up problems were

considered a more serious threat than the quality of the technology at the time the deal to

purchase the technology was struck.

       The main evidence for the significance of the hold-up problems and the

insignificance of asymmetric information comes from the initial stage of the project in

which Nokia solicited offers for the technology from about twenty firms. The firms and

the associated prices, where explicitly given in the documents, are displayed in Table I.

Several large semiconductor manufacturers, including Motorola, Philips, Siemens and

Texas Instruments, did not show any interest, and in some cases the technology offered by

smaller manufacturers appeared to be inappropriate. Of those remaining the MPSI’s offer

was the cheapest. The payment schedule suggested by MPSI was the most front loaded. If

asymmetric information on the quality of the technology were a serious problem, Nokia

should have inferred that MPSI had low-quality technology. A firm with high-quality

technology would require a high price and a payment schedule in which most of the

payments would take place at the later stages. MPSI’s technology was also rather unusual

and generally less known than the technologies offered by its more prestigious

competitors.

       The second piece of evidence is somewhat indirect. Nokia became the third

largest shareholder in MPSI, the value of the shares being twice as high as the combined

licence-fees. We cannot see why Nokia would buy any part of MPSI if there were

uncertainty about the quality of its product. In contrast, there are at least two explanations

emanating from the hold-up problem. In Hart’s (1995) model joint ownership is optimal


                                             18
if the parties invest in physical capital, and the returns are large enough. A major part of

the investment was in the factory, and to a lesser extent in testing equipment. In Pisano

(1989) such direct equity participation is justified by the desire to align incentives for co-

operation. The ownership arrangement is thus at least consistent with being a response to

a potential hold-up problem.

        Although the payment schedule of the contract directly supports neither

hypothesis, it includes an option-to-own arrangement that is a known solution to the hold-

up problem (e.g., Nöldeke and Schmidt, 1998). In principle, if the contract solely aimed at

eliminating the hold-up problem, the full payment should take place after the training. In

reality matters were slightly more complicated than in theory. The option-to-own part was

about 10% of the total fee. For Nokia the value of the licence depended on the quality of

training. Without appropriate training the license would have been less valuable than with

proper training, but not worthless. Nokia received many valuable documents, e.g., design

rules and a cell library, in any event.

        Nokia agreed to pay the price of the less valuable licence at the outset, and the

option-to-own arrangement applied to the licence with proper training. If Nokia did not

regard the training as good enough or, for some other reason, did not require assistance in

plant construction before the end of 1983, there was to be a reduction of $162,500 in the

price of the licence. It was obviously thought that the uncertainty about technology quality

and training was to be resolved by the end of 1983. In order to avoid deception by Nokia,

the contract specified that Nokia was liable for the full amount if it nevertheless started

the construction before the end of 1986.




                                             19
       In the light of pure cash payments the maximal resources that MPSI would devote

to the training had to be below the reduction of $162,500. One would expect that the

efforts by MPSI were just enough to justify the plant construction. The reports sent by

Nokia’s engineers from the training sessions in California indicate that MPSI did not

commit much resources to the training. While there were also complaints of the quality of

the technology, the majority of them concerned training. In the end the training must have

been considered sufficient because the decision to construct the manufacturing plant in

Finland was made in spring 1984. It thus seems that MPSI was shirking on training but

that the savvy contractual payment scheme negotiated between Nokia and MPSI led

MPSI to provide enough training in spite of these shirking temptations.

       MPSI had also other incentives to enter into the agreement than direct cash

payments. In favourable circumstances Micronas would become a second source for

MPSI. However, in accordance with the standard hold-up problem, after the investments

in providing the suitable training and assistance in plant construction were sunk, the

bargaining position of MPSI would be weak. Thus MPSI was unwilling to provide

training before the agreement on the licensing fee. These problems could have been

avoided if MPSI had given Micronas an exclusive license. But this would have been

problematic from MPSI’s point of view, since there was uncertainty about the success of

technology transfer; if it had failed MPSI would have been without a second source.6 The

success of the technology transfer probably falls within the realm of things one cannot

contract for. This may also partially explain why the option arrangement constituted a

relatively small part of the total payment.




                                              20
       In sum, if asymmetric information had been a more significant concern than hold-

up problems, Nokia would not have accepted MPSI’s offer, the semiconductor plant

would not have been constructed in Finland, and MPSI’s technology could not now be

used successfully by Micronas. There are of course counter-arguments. The complaints

on the quality of training could be “cheap talk” grousing with no implications for the

contract’s effect. There could also be alternative justifications for the plant construction.

Even with poor training, Micronas could have achieved sufficient knowledge to design

and manufacture semiconductors through learning-by-doing effects. As the studies by

Irwin and Klenow (1994) and Gruber (1998) suggest, the importance of learning-by-doing

effects in the semiconductor industry is undeniable, and it is reasonable to suppose that

these effects facilitated the construction decision. The founders of Micronas could also

have undertaken to establish the semiconductor plant in Finland in exchange for financial

support from the policy-makers. This explanation seems implausible, since the debt

contract with SITRA clearly states that Nokia would have been able to escape from some

repayments by dropping the Micronas project by the end of 1989.




6. Conclusion



In this study we employ the extensive information from an international technology

transfer from U.S. to Finland. We provide evidence that both asymmetric information and

hold-up problems were recognised as potential impediments before the contract and

remained such after the contract was written, despite the efforts to avoid them. In our


                                             21
view, however, it is clear that the hold-up problems were a more serious concern in the

design of the contract than asymmetric information.

       In a desire to pin down explicitly the underlying contractual framework of the

technology transfer, we have made several less than satisfactory simplifications. We

analyse the hold-up problem in one model, and asymmetric information in another. A

proper investigation of the technology transfer would deal with both problems within the

same model. To the extent that there are two different and separate problems, our

approach has little empirical cutting edge, since the two models yield qualitatively similar

optimal contracts. This finding may also be a hint that some critical features of

contracting are missing from the established theories.

       If it were possible to estimate the cost increase caused by the choice of wrong

technology and the hold-up problems, we could make a better case for how the evidence

supports one theory or the other. As we cannot, we have to resort to evidence that is

extraneous to the models in order to evaluate the relative significance of the problems.

We find that asymmetric information is less important than hold-up problems at the time

of contracting. This, of course, does not necessarily indicate that asymmetric information

is unimportant in patent licensing; it is conceivable that it can be affected by the parties,

and this most likely takes place before contracting.

       Perhaps the main purpose of a case study is to formulate challenges for large

sample examinations. We hope that the next step in the research is to empirically

elaborate the role and the significance of asymmetric information in technology transfer.




                                             22
Acknowledgements:



We are greatly indebted to an anonymous referee, Bengt Holmström and Mihkel Tombak

for thorough comments. We thank Heikki Ihantola, Urho Ilmonen, Pauli Immonen,

Anneli Saarikoski, Eero Vallström, Tapio Wiik, and Titta Wäre for useful and

informative discussions, help with archives and documents, and their patience. We should

also like to thank Mikko Mustonen, Otto Toivanen, and seminar participants at the MIT,

the Royal Economic Society Conference at the University of Warwick, at the 25th

E.A.R.I.E Conference in Copenhagen, at the 3rd Helsinki Workshop on Standardization

and Transportation, and at the FPPE seminar in Helsinki for helpful comments. Takalo

gratefully acknowledges financial support from the Yrjö Jahnsson Foundation. Part of this

research was conducted when Takalo was visiting the Departments of Economics at the

MIT and at the Boston University.




Notes:


1. Some of our information has been gathered from public sources, but our evidence mainly consists of the

private documents on the files of Nokia and Micronas, including the memorandum of association for the

research joint venture and the contract for technology transfer together with their later amendments,

strategic plans, and investment plans. The evidence from documents is supplemented by information

obtained from interviews with some key personnel in the Micronas project, including the managing director

of the company in 1980-1987. The data extends to 1992 after which the Finnish owners sold Micronas to a




                                                   23
Swiss company. Our analysis has therefore little to do with Micronas today, which is listed on the Zürich

stock exchange.

2. Aspo spun off its electronics operations into a separate company, Aspocomp, in 1999. Both Aspo and

Aspocomp are currently listed companies traded on the Helsinki Stock Exchange.

3. As the history of Nokia, edited by Lemola and Lovio (1996), illustrates, Nokia had already utilised a

similar strategy several times when moving into new businesses; in fact, Nokia was founded in 1865 by

using this strategy of imitation and development.

4. The wording in italics is as in the original contract. The clarifications in parentheses are added by the

authors.

5. The complete contract foundations to the incomplete contract theory is currently the subject of a debate,

see e.g., Hart and Moore (1999), Maskin and Tirole (1999), and Tirole (1999). As explained in Hart and

Moore (1999), if one is unwilling to invoke bounded rationality to explain the observed incompleteness of

real-world contracts, at some level the debate is reduced to a matter of taste whether to call a contract

‘incomplete’ or ‘optimal subject to commitment and incentive constraints’. We leave it to future research to

yield a complete theory of ownership. Meanwhile, we are content to rely on the standard incomplete

contract model.

6. Micronas was used as MPSI’s second source from the beginning of 1986 until the end of 1989. The

volume of the second source activity was, however, smaller than the firms had initially expected.




References



Begg, A., 1992, ‘The licensing of patents under asymmetric information’, International

           Journal of Industrial Organisations, 10, 171-194.

Gallini, N. and B. Wright, 1990, ‘Technology transfer under asymmetric information’,

           RAND Journal of Economics, 21, 147-159.


                                                    24
Gruber, H., 1998, ‘The evolution of market structure in semiconductors: the role of

       product standards’, mimeo, European Investment Bank.

Hart, O., 1995, Firms, Contracts and Financial Structure, Oxford: Oxford University

       Press.

Hart, O. and J. Moore, 1999, ‘Foundations of incomplete contracts’, Review of Economic

       Studies, 66, 83-114.

Irwin, D. A. and P. J. Klenow, 1994, ‘Learning-by-doing spillovers in the semiconductor

       industry’, Journal of Political Economy, 102, 1200-1227.

Kultti, K. and T. Takalo, 2000, ‘Incomplete contracting in an R&D project: the Micronas

       case’, R&D Management, 30, 67-77.

Macho-Stadler, I. and J. D. Pérez-Castrillo, 1991, ‘Contracts de licences et asymétrie

       d’information’, Annales d’Économie et de Statistique, 24, 59-92.

Maskin, E. and J. Tirole, 1999, ‘Unforeseen contingencies and incomplete contracts’,

       Review of Economic Studies, 66, 83-114.

Nöldeke, G. and K. M. Schmidt, 1998, ‘Sequential Investments and Options to Own’,

     RAND Journal of Economics, 29, 633-653.

Pisano, G. P., 1989, ‘Using equity participation to support exchange: evidence from the

       biotechnology industry’, Journal of Law, Economics, & Organization, 5, 109-126.

Tirole, J., 1999, ‘Incomplete contracts: where do we stand?’, Econometrica, 67, 741-781.

Williamson, O. E., 1975, Markets and Hierarchies: Analysis and Antitrust Implications,

       New York: The Free Press.

Williamson, O. E., 1985, The Economic Institutions of Capitalism, New York: The Free

       Press.


                                           25
Williamson, O. E., 1989, ‘Transaction cost economics’, in R. Schmalensee and R. D.

       Willig (eds), Handbook of Industrial Organizations, I, Amsterdam: Elsevier

       Science Publishers.

Wright, D. J., 1993, ‘International technology transfer with an information asymmetry

       and endogenous R&D’, Journal of International Economics, 36, 47-67.




Appendix

Patent licensing under asymmetric information



We develop a simple model in order to capture the essential aspects of the technology

transfer under asymmetric information. The other aim is to show that the use of royalties

in licensing contracts cannot be explained satisfactorily by asymmetric information.

       Let us assume that there is a company (MPSI) possessing a suitable basic

technology and a company (Nokia) that has the ‘idea’ of developing the technology

further. We assume that the technology offered by the licensor can be either good or bad,

and that the licensor knows the quality of its technology perfectly but the potential

licensee knows only the distribution of quality. We normalise the value of the technology

for the licensor to zero, and assume that the expected value of the buyer’s ‘idea’ is v. The

cost of developing the idea is uncertain and depends on the quality of the basic

technology. The cost can be either cl or ch such that cl < ch. After the first training period

the uncertainty about the development costs resolves itself. Without loss of generality, we




                                             26
assume that it is impossible for the licensee to invent around the licensor’s patented

technology.

       We investigate whether the licensor can signal the quality of the technology

through a contract similar to that written by MPSI and Nokia. The fee schedule depicted

in section 2 shows that the contract does not use royalties. We reduce the fee schedule to

two stages. Let F denote the fee for the initial training period, and S the combined fees for

the second training period and plant construction. The problem of the licensor with low-

cost technology is to maximise revenue from licensing subject to the participation

constraint and the incentive compatibility constraint, that is, the problem is to maximise

Fl+Sl subject to

PC                                  Fl+Sl ≤ v-cl                                        (1)

IC                             Fl ≤ v-ch and Sl ≥ v-ch                                  (2)

in which subscripts l and h denote the low- and high-cost technology. If S≥v-ch, the

licensee does not make the second-stage payment when the technology turns out to be

costly. Consequently, the licensor with low-cost technology can convince the licensee of

the true value of the technology by setting Sl≥v-ch and Fl≤v-ch.

       In the pooling equilibrium the licensee assigns some probability p that the licensor

has low-cost technology. In other words the total fee in the pooling equilibrium is equal to

                                p(v-cl) + (1-p)(v-ch).                                  (3)

We focus on the separating equilibrium in which the licensing agreement credibly signals

the quality of technology. As the proof of Proposition 1 will show, the separating

equilibrium always exists when v-ch>ch-cl. If v-ch<ch-cl, however, we need to restrict




                                             27
probability p to guarantee that the licensor with low-cost technology prefers the

separating equilibrium.



                                               v - ch
ASSUMPTION 1. If v-ch < ch-cl, then p <               .
                                              ch − cl



PROPOSITION 1. The licensor with low-cost technology employs a staggered fee

schedule whereas the licensor with high-cost technology employs only a single fee. More

specifically:

        i) The simplest contract when the technology is low-cost is

                           Fl=min {ch-cl, v-ch} and Sl=v-ch.

        ii) The revenues for the licensor with low-cost technology are

                               Fl+Sl=min {v-cl, 2(v-ch)}.

        iii) The licensor with low-cost technology sets both Fl and Sl as strictly positive,

and the licensor with high-cost technology sets Fh=v-ch and Sh=0.



Proof: i) By incentive compatibility constraint (2), Sl≥v-ch and Fl≤v-ch. When Sl≥v-ch,

constraint (1) implies that Fl≤ch-cl. Thus, Fl≤ min{ch-cl, v-ch}. The contract with Fl=ch-cl

and Sl=v-ch clearly satisfies (1), and if ch-cl≤v-ch, it also satisfies (2). Accordingly, the

contract with Fl=v-ch and Sl=v-ch clearly satisfies (2), and if v-ch≤ch-cl, it also satisfies (1).

        ii) The contract Fl=min {ch-cl , v-ch} and Sl=v-ch immediately yields Fl+Sl= min

{v-cl, 2(v-ch)}.




                                               28
       iii) If v-ch≥ch-cl, the licensor with low-cost technology receives v-cl, and is clearly

better off with the staggered schedule than with the single fee given by (3). If v-ch<ch-cl,

the licensor with low-cost technology receives 2(v-ch), and is better off when assumption

1 holds. Thus, the licensor with low-cost technology employs the staggered fee schedule,

and the licensor with high-cost technology then has no reason to use any fee at the second

stage, and sets Fh=v-ch and Sh=0.

                                                                                     QED




                                             29
                                                          Figure 1

                                          The performance of Micronas.

             The figures for year 1981 cover the period 1.10.1980-31.12.1981




                                                        Performance

      50,000,000

      40,000,000

      30,000,000

      20,000,000

      10,000,000
                                                                                                   Net sales
FIM
               0                                                                                   Operating profit


      -10,000,000

      -20,000,000

      -30,000,000

      -40,000,000
                            1982

                                   1983

                                          1984

                                                 1985

                                                         1986

                                                                1987

                                                                       1988

                                                                              1989

                                                                                     1990

                                                                                            1991
                    1981*




                                                                30
                                                Table I
           The potential licensors, their turnover from the semiconductor business,
                                    and their offers for a licence


Company name                                         Turnover                            Offer
AMD                                                      440
AMI                                                      300
Exar Integrated Systems
Fairchild                                              1100
Hitachi
Hughes                                                    60
ITT                                                                                       8.22
Microelectronic-Marin
Mostek                                                   480
Motorola
MPSI                                                      60                              7.85
NEC                                                      600
Philips
Plessey Semiconductors                                   120
RCA                                                      520                             10.89
SGS-ATES                                                 600                               9.82
Siemens
Synertek                                                 150
Texas Instruments
Thomson-CSF


The turnover from the semiconductor business and the prices for a licence are displayed only if given
explicitly in the documents. Otherwise the documents merely state that a company was not willing to
license, the prices were too high, or that the technology offered was insufficient. ITT’s offer is from 1980
and in German Marks, unlike the others which are in Finnish Marks from 1979. We have converted it to
Finnish Marks using the average exchange rate for 1980.




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